Deducting state income taxes: some questions

Factual Questions
1

For the first time, I have enough deductions to itemize, but I think I deducted too much, and now I have to fix it.

I used TaxAct to do my federal return, and it listed all the tax that was withheld by CA on Sch A. However, after I did my state taxes, I got a refund. So I’m pretty sure that means I need to go back to the Federal return and amend it to show that I paid less in state income taxes.

The reason I’m confused by this is that TaxAct showed numbers for both federal refund and state refund. If they knew that I’d get a state refund, why did they include the full amount withheld in my federal deductions? Maybe because I didn’t actually do my state return with them? If so, I now understand why they’ll let you file your federal return for free and only pay for the state return. You have to do the state return with them or they do the federal return incorrectly. :frowning:

In the past, I’ve always done my federal return first, then done my state return. But now it sounds like I probably have to do them simultaneously, since you can’t really finalize either one until some work has been done on the other. Is this what other people do?

Finally: Since I’m going to get more money back from the Feds than I should, will I have to pay penalties/interest? The difference is only going to be about $200. If I file my amended return with a check before April 15 I should be fine, right?

2

You don’t need to amend the Federal return. When you file your 2012 taxes next year, you’ll report the refund you get from the state for your 2011 taxes as regular income for 2012. Your state will send you a 1099-G (in January maybe?) that shows that you received a taxable refund. TaxAct will most likely take care of all of this for you - I know Turbotax does.

3

Right – next year the state will send you a 1099-G which reports to the IRS the refund that you got from the state. There is a line on the 1040 which you will report refunds of state or local taxes, and you’ll pay Federal income tax on that refund next year.

4

Ok, that makes sense.

Except I don’t believe I’ve ever gotten a 1099-G from the state, and I’ve received refunds from them most years.

I guess, since I didn’t itemize deductions in the past, the state tax refund wasn’t taxable income?

5

Correct - the state tax refund isn’t taxable if you didn’t itemize for that year, because it’s included in the standard deduction. I’d guess sending a 1099-G to people who don’t have to report it would just cause more errors on the federal taxes. I don’t know how the state would know if you itemized your federal return though, unless the IRS tells them directly.

6

Sweet. Ok, thanks to both of you for the very quick responses.

7

Right, what my Bro does is sometimes suggest that when the filer is itemizing for the first time, then a note be placed on the “taxable refunds” line stating “did not itemize in 2010”. Sometimes might forestall a inquiry letter or a delayed refund.

Now, here’s why this works like it does. In any given year, your NET detection should be the difference between what you paid/withheld and what you got back, .But you are a cash basis taxpayer, thus you deduct what you paid, and include what you got back…. Except in your first year of itemizing as you had “no tax benefit” last year. This same can be extended if you barely had enough to itemize, say by only $300. Thus, in that case, even if you got a $1000 refund next year, your “tax benefit’ would only be $300, and only $300 of that refund would be taxable.

8

Many states require a copy of the federal return to be filed along with the state return. I know that California is one of these.

9

I have never filed a copy of my federal return. I do my CA return online through CalFile, the CA FTB operated online service.

10

California requires a copy of your federal return only if you paper file and your federal return includes a form other than 1040/A/EZ or includes a schedule other than Schedule A or Schedule B. See page 17 of the Form 540 Instructions (pdf).

In the name of cost-savings a number of states have launched a mini-rebellion and are no longer mailing copies of Form 1099-G to their taxpayers. You should not assume that they aren’t filing with the IRS, however.

One common mistake that taxpayers make is assuming that the entire refund (as shown on Form 1099-G) is taxable income. Only the net tax benefit you received is taxable. For example, let’s say the standard deduction is $11,400 (married filing jointly in 2010). In 2010, your itemized deductions were $12,000. In 2011, you get a state tax refund for $2000. You only need to report $600 ($12,000 minus $11,400) on your 2011 return, not $2000, despite the fact that your 1099-G says $2000. You also need to remember this if the AMT prevented you from taking full advantage of the state tax deduction or if, after the refund, it would have been more advantageous to you to take the sales tax deduction in 2010. See the discussion beginning on page 22 of Publication 525 (pdf).

11

So, they must be getting some information from the IRS if they know not to send 1099-Gs to people who didn’t itemize.

12

States do get copies of your federal returns from the IRS, but not in time to make this decision. By the way, this often bites people who move at the beginning of the year. Let’s say someone lived in California all 2011, then in January 2012 moves to Oregon. In February 2012, he files his federal return with his new Oregon address. A couple of years later, the IRS sends his return to the Oregon Department of Revenue which then sends out a nasty letter demanding to know why he didn’t file an Oregon return for 2011. But I digress.

I don’t know why you have never received a 1099-G from California. You can find copies of the 1099-G forms that California (claims to have) sent you for the last several years at MyFTB Account.

13

I just looked.

14

Just to expand on the answers already given to the OP, if you use TaxAct again next year, it will automatically import your return from this year and the amount of the state refund will already be filled in for you, so you won’t need to enter anything from the 1099-G which you receive.

15

Won’t that only be true if I used it for my state return? I didn’t use it for my state return because it costs $15 for that, and the CA website is free and very easy to use.

16

Yes, you are correct.

17

There’s a simple trick it may pay to know.

Taxes are deductible the year you pay them. If you pay your 2011 state tax now, and your 2012 state tax in December, both payments can be deducted on your 2012 federal form. This may do little good if you itemize deductions every year, but for some taxpayers you’d get a double deduction in even-numbered years, while taking the standard deduction in odd-numbered years.

Disclaimers: IANAL; IANACTP (but I was told of this trick by a Certified Tax Preparer). My info is 20 years old, so perhaps IRS no longer allows this.

18

Can you pre-pay state income tax like that?

Could I just pre-pay several years at a time, then not take the refund? That seems like an odd loophole.

19

I lack the knowledge to say any more. It does seem an odd loophole, and what was legal 20 years ago may not still work. The tax preparer who advised me implied that it was a well-known trick.

I was self-employed, which of course gives one more flexibility about when to pay income tax.

20

Many people who owe taxes on income that is not subject to withholding (for example, people who are self-employed or who live off their investments) need to pay their taxes directly to the state in quarterly installments. In most states, the last installment for for 2011 is due January 15, 2012. Similarly, if you fill out your 2011 state tax return and discover that you owe the state a few dollars, the remaining balance for 2011 is due April 15, 2012.

As a cash basis taxpayer, you deduct the payments in the year you made them, not the year they were due. So, if you made your final state tax payment for 2011 in January or April of 2012, you would have to wait until you file your 2012 tax return in order to take a deduction for that payment, even though it was a payment of your 2011 taxes.

Now, if you realized in December 2011 that you were going to owe a balance on your 2011 taxes, you could hurry up and send it in December 2011 instead of waiting until the due date. This would allow you to take a deduction on your 2011 federal tax return for the payment instead of waiting until 2012. But I know of no state that would, for example, accept a 2013 income tax payment in 2011.

So if, for example, you know you are going to be in a lower tax bracket in 2012 (maybe you are retiring or going back to school), why not make a humongous estimated tax payment in 2011, take a deduction in 2011, and then pay tax on the refund in a lower bracket in 2012? The IRS addressed this issue in Revenue Ruling 82-208 where it held that a cash basis taxpayer “may not deduct an estimated state income tax payment if on the date of payment [the taxpayer] could not reasonably determine, in good faith, that there is an additional state income tax liability.” The definition of “reasonably” may ultimately be left to a judge to decide if it comes to that.

On the other hand, timing your deductible expenditures so that they fall into a single year is a valid tax strategy known as “bunching.” The idea is to take itemized and standard deductions in alternating years. So, for example, instead of making donations to your favorite charity every year, make a double donation in even numbered years and no donation in odd numbered years. If your real estate tax is due in January, in even numbered years make one payment in January and your next year’s payment in December. Where you have a choice to speed up a payment, make it in the even numbered year.