In tax terminology, the phrase “tax benefit rule” refers to whether or not a refund or recovery received in a future year is taxable. For example, whether or not a state income tax refund is taxable on your federal return depends on the “tax benefit rule.”
The key question under this rule is, did you receive a tax benefit from taking a deduction for the refund item in a prior year?
Let’s look at state tax refunds as an example.
Let’s say you receive a $1,000 refund from Iowa when you filed your 2016 tax return in 2017. This refund may or may not be taxable on your 2017 federal tax return, depending on the tax benefit rule.
(This is a vast oversimplification of the rule, by the way.)
The way to look at the rule is, what would your tax return have looked like if you had NOT claimed the deduction? If you didn’t derive a benefit from claiming the deduction, the refund isn’t taxable.
You receive an Iowa tax refund of $1,000 when you filed your 2016 tax return in 2017. On your federal return for 2016, you claimed the standard deduction rather than itemized deductions — meaning you didn’t claim a deduction for state income taxes paid. Because you didn’t deduct state income taxes on your federal return, you didn’t receive a “benefit” from the deduction (a deduction you didn’t take!), so the refund is not taxable.
Let’s say everything is the same as the previous example except you had a total of $13,000 of itemized deductions on your federal return. Let’s say you’re married, so your standard deduction on that federal return for 2016 was $12,600. You claimed an itemized deduction of $4,000 of state taxes paid.
The first step here is to factor out the $4,000 deduction for state taxes paid. If that deduction wasn’t taken, you would have claimed the $12,600 standard deduction. Your “tax benefit” is the difference between the $12,600 deduction you would have claimed without the state tax deduction versus the $13,000 you actually claimed. That results in a $400 difference, which is your “tax benefit.” Of the $1,000 refund you receive from Iowa, $400 of it will be taxable on your 2017 federal return.
Yet Another Example:
Let’s say everything is the same as the last example except your total itemized deductions total $20,000. Factoring out the $4,000 of state taxes gives a result of $16,000. The difference between the deduction you would have taken without the state tax deduction ($16,000) vs your total itemized deductions ($20,000) is … $4,000. You received a full “tax benefit” from the $4,000 state tax deduction. So, your $1,000 refund will be fully taxable on your 2017 federal return.