Question

Explain the tax benefit rule and use state income tax as an example.

Answer 1

The “tax benefit rule” states whether or not a recovery or refund received in a future year is taxable. For instance, whether or not a state income tax refund is taxable on the federal return depends on this rule. When a tax deduction is claimed on Schedule A, such as state and local income taxes withheld, and then receives a "tax benefit," as the deduction has reduced the taxable income and thus the tax liability.

For example: Suppose you receive a $2,000 refund from Iowa on filing 2016 tax return in 2017. Depending on the tax benefit rule this refund may or may not be taxable on your 2017 federal tax return.