Most residents in states that distributed some kind of stimulus payments or tax rebates last year don’t have to report them on their federal returns. But some residents in four states do — largely because of how their states designed these payments.
Taxpayers in Georgia, Massachusetts, South Carolina, and Virginia who received state tax refunds and claimed the state and local tax (SALT) itemized deduction without surpassing its cap have to pay federal taxes on those payments, according to a recent Internal Revenue Service ruling.
But residents in 17 other states don’t have to pay any federal taxes on their state payments received in 2022 in the “interest of sound tax administration and other factors,” the agency found.
Why these four states’ payments are federally taxable comes down to how the states defined these payments, Jared Walczak, Tax Foundation’s vice president of state projects, told Yahoo Finance.
“The IRS has singled out these four states because they structured their rebates as tax refunds,” he said, rather than tax rebates or stimulus payments. “And therefore the IRS is regarding them as a reduction of net state tax liability.”
Here’s how that works.
Say John had $5,000 withheld from his paycheck for state taxes. When he filed his federal return, he chose to itemize and deducted $5,000 for state and local taxes — commonly called the SALT deduction.
But when John later filed his state tax return, he only owed $4,000 to the state government based on his income, so he got a $1,000 tax refund even though he deducted the full $5,000 on his federal taxes. John’s state then would send a 1099-G form to report the $1,000 refund as taxable income on his following year’s federal return.
The IRS considers these payments from the state in a similar manner for taxpayers who took the SALT deduction and benefited from it. Taxpayers in those states who took the standard deduction or who took the SALT deduction but it exceeded the $10,000 limit are not affected.
“The tax benefit rule says to the extent that you deducted something in the past and then you got a refund of it, the amount of the refund is taxable,” Vivian Paige, a certified public accountant based in Norfolk, Virginia, told Yahoo Finance.
“You had to have a tax liability in order to receive this money,” she added. “So if you filed a return with zero liability, you did not get the money.”
In Virgina, the state anticipated the final guidance from the IRS and had already declared the state payments as taxable for federal purposes, according to its Department of Taxation.
“Virginia had already told everybody that if they got the rebate, it was going to be included on the 1099 that they received from the state,” Paige said.
The four states
In the four states the IRS singled out, only residents who owed state taxes received a state rebate. Here is a summary of each of them.
Georgia: Thanks to a historical state budget surplus, the state of Georgia distributed surplus tax refunds to its residents in 2022. The payments amount were $250 or $500, depending on filing status, and were capped by the lesser of those amounts or the total tax liability on their 2020 return. This means a single filer with $100 tax liability in 2020 received a $100 refund instead of the full $250 refund.
Massachusetts: Revenue collected in 2022 surpassed the state’s legal annual tax revenue cap. As such, taxpayers received a refund of 14.0312% of their 2021 tax liability. This also means that state taxpayers only received the refund if they incurred a state tax liability on their 2021 income tax return.
South Carolina: The state governor approved the tax refund for 2022 for state residents up to $800. Taxpayers only received the rebate if they incurred tax liability on their 2021 income tax return.
Virginia: Eligible residents received one-time tax rebates of up to $250 (single filers) and $500 (joint filers) as a payment to “help families lower the cost of living” in a high-inflation era, according to the state governor. Taxpayers only received the rebate if they incurred a tax liability on their 2021 income tax return.
Although the decision to tax these refunds is technically correct, Walczak questioned why the IRS insisted on the refund distinction “given their willingness to disregard rules in 17 other states,” he said.
Another issue is the agency’s lack of instruction for affected taxpayers who already submitted their tax return without reporting the state stimulus amount.
“Presumably,” Walczak said, “any affected taxpayers who have already filed and did not include their tax refunds as taxable income will be required to file an amended return.”
Rebecca is a reporter for Yahoo Finance.
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