Soon you will be preparing your 2012 tax return. When you do, you will need to look back and check your 2011 state tax return to see if you paid in additional state taxes or received a state refund in 2012 (for 2011).
If you paid in additional state taxes in 2012 for 2011 (or other prior years), that amount can be added to any other state taxes paid (such as state tax withholding on wages) in 2012 and deducted on Schedule A, if you itemize deductions in 2012. Note that only the tax amount is deductible, not late payment penalties or interest.
If you received a state tax refund in 2012 (for 2011), it may be fully taxable, partially taxable, or not taxable at all. Let’s start with the easy answer first: if you did not itemize deductions (but took the standard deduction) on your 2011 federal return (Form 1040), using Schedule A, then none of your 2011 state refund received in 2012 will be taxable on your 2012 federal return.
If you did itemize deductions on Schedule A in 2011 and correctly deducted all of your state tax withholding or other separate payments (such as state estimated tax payments), then some or all of your 2011 state refund (received in 2012) will be taxable on your 2012 federal tax return (Form 1040, line 10). The taxable portion of your refund is limited to the amount by which your total itemized deductions exceeded the standard deduction you could have claimed in 2011.
EXAMPLE 1; Partial taxation: On your 2011 return, you filed as a single taxpayer. You claimed itemized deductions of $6,445, of which $2,325 was for state income taxes. Your deductions exceeded by $645 the $5,800 standard deduction you could have claimed. In 2012, you received a state refund of $960 for 2011 state income tax. You must report only $645 of the refund as income on your 2012 Form 1040, line 10. The taxable recovery is limited to the $645 difference between the claimed itemized deductions of $6,445 and the $5,800 standard deduction (for a single taxpayer) for 2011.
EXAMPLE 2; Full taxation: On your 2011 return, you filed jointly with your spouse. You claimed itemized deductions of $14,900 of which $3,500 was for state income taxes. Your deductions exceeded by $3,300 the $11,600 standard deduction you could have claimed. In 2012, you received a state refund of $1,255 for 2011 state income tax. You must report the full refund of $1,255 as income on your 2012 Form 1040, line 10. The taxable recovery limit in this instance would be up to $3,300, the difference between the itemized deductions claimed of $14,900 and the standard deduction of $11,600 (married, filing jointly) for 2011.
The same rules apply to local (city or county) income taxes. State refund amounts are reported to you and the IRS on Form 1099-G.