Income and Assets · Income

State and local income tax refunds and other itemized deduction recoveries

A refunded deduction is not automatically income. Section 111(a) excludes a recovery to the extent the amount deducted in the earlier year did not reduce the tax for that year, so the question is always what the deduction actually bought. For state and local taxes that question has become harder rather than easier, because a cap sits on the deduction and the cap itself changed for 2026.

The rule

The tax benefit rule, stated exactly. Gross income does not include income attributable to the recovery during the taxable year of any amount deducted in any prior taxable year to the extent such amount did not reduce the amount of tax imposed by chapter 1 (IRC § 111(a)). The exclusion is measured by tax reduction, not by whether a deduction was claimed — so a deduction that was claimed but produced no tax saving yields no income when it comes back.

Three ways a deduction produces no benefit. The taxpayer took the standard deduction rather than itemizing (IRC § 63(b), (c)), so the state tax was never deducted at all. The taxpayer itemized but the total was below what the standard deduction would have given. Or the deduction was disallowed by a limitation — which for state and local taxes is now the usual case.

The state and local tax limitation, as it now stands. For an individual, foreign real property taxes are not taken into account, and the aggregate of income, real property and personal property taxes under § 164(a)(1)–(3) plus § 164(b)(5) may not exceed the applicable limitation amount, half that for a married individual filing separately (IRC § 164(b)(6)). The limitation does not reach foreign taxes described in § 164(a)(3), nor taxes under § 164(a)(1) and (2) paid or accrued in carrying on a trade or business or a § 212 activity.

The applicable limitation amount is now a schedule, not a number. IRC § 164(b)(7)(A) sets a figure for a taxable year beginning in 2025, a higher figure for 2026, then a small annual step-up for taxable years beginning after 2026 and before 2030 — and a sharp reversion to the old figure for taxable years beginning after calendar year 2029 (IRC § 164(b)(7)(A)(iv)).

And it phases down. For any taxable year beginning before 1 January 2030, the applicable limitation amount is reduced by a percentage of the excess of modified adjusted gross income over a threshold amount, halved for a married individual filing separately (IRC § 164(b)(7)(B)(i), (ii)) — but the reduction may never bring the applicable limitation amount below the reversion figure (IRC § 164(b)(7)(B)(iii)). The current amounts are in the table below.

Reporting is low and unchanged. Every person making payments of refunds of State or local income taxes, or allowing credits or offsets, aggregating a small figure or more for an individual in a calendar year must file an information return (IRC § 6050E(a)).

Current figures

How it works in practice

Never treat a Form 1099-G figure as the answer. It reports what the state refunded; § 111(a) asks what the earlier deduction did, and those are different questions. The recomputation is done on the prior year’s return, not on this one.

The method is to rework the earlier year twice. Compute that year’s tax as filed, then recompute it with the state and local tax deduction reduced by the refund. The difference in tax is the benefit, and the includible amount is capped by it. Where the taxpayer took the standard deduction, the difference is nil and so is the income. Where they itemized but only just, the includible amount is limited to the excess of the itemized total over the standard deduction they could have taken.

The limitation adds a step that catches people out. Where a taxpayer’s state and local taxes exceeded the applicable limitation amount in the earlier year, the extra tax they paid produced no deduction, so refunding it produces no income. In the years when the cap stood at ten thousand dollars this excluded most refunds in high-tax states almost automatically. For 2026 the cap is far higher, so the arithmetic has to be done again rather than assumed — a refund that would plainly have been excluded on a 2024 return may be includible on a 2026 one.

Two further points worth raising with clients. The phasedown means a high-income taxpayer’s limitation is not the headline figure, and its floor means it never falls below the old amount. And because the schedule reverts after 2029, a payment made in one year rather than another can change the deduction substantially — which makes the timing of a state estimated payment a live question in a way it has not been for several years.

How this has changed

The state and local cap was made permanent and then rebuilt. Pub. L. 119-21 § 70120(a)(1) struck “and before January 1, 2026” from § 164(b)(6), so the limitation no longer expires. Section 70120(a)(2) replaced the fixed dollar figures with a reference to “the applicable limitation amount”, and § 70120(b) added § 164(b)(7) to define it — a year-by-year schedule with an income phasedown, a floor, and a reversion after 2029.

Two consequences for this topic. First, the arithmetic has to be done again. In the years when the cap stood at its old level, a taxpayer in a high-tax state almost always had taxes above it, so a refund was almost always excluded under § 111(a) without much analysis. At the 2026 figure that shortcut fails, and a refund that was plainly excluded on a 2024 return may be includible on a 2026 one.

Second, timing matters again. Because the applicable limitation amount rises modestly through 2029 and then falls back sharply, whether a state estimated payment lands in December or January can change the deduction by a large amount — a planning question that had gone quiet while the cap was flat.

A drafting artefact worth knowing. Section 70120(a)(1) struck the end date from the text of § 164(b)(6) but left its heading reading “Limitation on individual deductions for taxable years 2018 through 2025”. The heading is now inaccurate. This is the third instance of a Pub. L. 119-21 amendment leaving stale text or a moved address behind, after the § 67(g) to § 67(h) redesignation and the rewrite of § 199A(i).

Exam focus

Answer every recovery question with § 111(a): income only to the extent the earlier deduction reduced tax. Expect a fact pattern where the taxpayer took the standard deduction, and one where itemized deductions exceeded the standard deduction by less than the refund.

Know that the state and local limitation is now a schedule under § 164(b)(7) rather than a fixed figure, that it phases down on income with a floor, and that it reverts after 2029.

Know what the limitation does not reach — foreign taxes under § 164(a)(3), and income and property taxes paid in carrying on a trade or business or a § 212 activity.

And know that the rule is general: § 111(a) applies to the recovery of any previously deducted amount, not only to tax refunds.

Check yourself

1. A taxpayer took the standard deduction for 2025 and receives a $1,800 state income tax refund in 2026. How much is includible?

Answer: none. IRC § 111(a) excludes a recovery to the extent the amount deducted in a prior year did not reduce the tax for that year. A taxpayer taking the standard deduction under IRC § 63(b) deducted no state income tax, so no part of the refund is a recovery of a deducted amount. The Form 1099-G is still issued under IRC § 6050E(a).

2. A taxpayer itemized $33,000 against an available standard deduction of $32,200, and receives a $2,500 refund. How much is includible?

Answer: $800. The benefit of itemizing was the $800 excess over the standard deduction. Reducing the earlier deduction by the full $2,500 would have put the itemized total below the standard deduction, at which point the taxpayer would have taken the standard deduction instead — so only $800 of the deducted amount actually reduced tax, and IRC § 111(a) excludes the rest.

3. Why could a refund of state income tax be wholly excluded even where the taxpayer itemized and had large deductions?

Answer: because of the § 164(b)(6) limitation. Where the taxpayer’s state and local taxes exceeded the applicable limitation amount, the excess produced no deduction and so reduced no tax, and IRC § 111(a) excludes a recovery to that extent. The analysis requires comparing the taxes paid with the applicable limitation amount for that year — which under IRC § 164(b)(7) now differs from year to year.

4. Does the tax benefit rule apply to anything other than tax refunds?

Answer: yes. IRC § 111(a) is written generally — it excludes income attributable to the recovery of any amount deducted in any prior taxable year to the extent that amount did not reduce tax. A reimbursed medical expense, a recovered bad debt, or a refunded charitable contribution is analysed the same way, by asking what the earlier deduction actually saved.