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Per IRS Publication 525 Taxable and Nontaxable Income, page 22:

Recoveries
A recovery is a return of an amount you deducted or took a credit for in an earlier year. The most common recoveries are refunds, reimbursements, and rebates of itemized deductions. You also may have recoveries of non-itemized deductions (such as payments on previously deducted bad debts) and recoveries of items for which you previously claimed a tax credit.

State tax refund. If you received a state or local income tax refund (or credit or offset) in 2017, you generally must include it in income if you deducted the tax in an earlier year. The payer should send Form 1099-G to you by February 1, 2018. The IRS also will receive a copy of the Form 1099-G. If you file Form 1040, use the worksheet in the 2017 Form 1040 instructions for Line 10 to figure the amount (if any) to include in your income. See Itemized Deduction Recoveries , later, for when you must use Worksheet 2 , later in this publication. 

If you could choose to deduct for a tax year either:

  • State and local income taxes, or
  • State and local general sales taxes, then
the maximum refund that you may have to include in income is limited to the excess of the tax you chose to deduct for that year over the tax you didn't choose to deduct for that year. 

Recovery and expense in same year. If the refund or other recovery and the expense occur in the same year, the recovery reduces the deduction or credit and isn't reported as income. 

Recovery for 2 or more years. If you receive a refund or other recovery that is for amounts you paid in 2 or more separate years, you must allocate, on a pro rata basis, the recovered amount between the years in which you paid it. This allocation is necessary to determine the amount of recovery from any earlier years and to determine the amount, if any, of your allowable deduction for this item for the current year. 

ExampleYou paid 2016 estimated state income tax of $4,000 in four equal payments. You made your fourth payment in January 2017. You had no state income tax withheld during 2016. In 2017, you received a $400 tax refund based on your 2016 state income tax return. You claimed itemized deductions each year on Schedule A (Form 1040). 

You must allocate the $400 refund between 2016 and 2017, the years in which you paid the tax on which the refund is based. You paid 75% ($3,000 ÷ $4,000) of the estimated tax in 2016, so 75% of the $400 refund, or $300, is for amounts you paid in 2016 and is a recovery item. If all of the $300 is a taxable recovery item, you will include $300 on Form 1040, Line 10, for 2017, and attach a copy of your computation showing why that amount is less than the amount shown on the Form 1099-G you received from the state. 

The balance ($100) of the $400 refund is for your January 2017 estimated tax payment. When you figure your deduction for state and local income taxes paid during 2017, you will reduce the $1,000 paid in January by $100. Your deduction for state and local income taxes paid during 2017 will include the January net amount of $900 ($1,000 - $100), plus any estimated state income taxes paid in 2017 for 2017, and any state income tax withheld during 2017. 


TaxAct does not calculate this allocation for state taxes. If the amounts for Prior Year State Income Tax Refund (to be included in taxable income on the current year's return) and the deduction for Prior Year State and Local Estimates Paid After 12/31/2014 need to be adjusted, the taxpayer would need to manually perform this allocation. 

To enter the recovery into the TaxAct program:
  1. From within your TaxAct return (Online or Desktop), click on the Federal tab. On smaller devices, click the menu icon in the upper left-hand corner, then select Federal
  2. Click State Income Tax Refund
  3. The program will proceed with the interview questions for you to enter or review the appropriate information

To enter the adjusted state and local income tax deduction on Schedule A into the TaxAct program:

  1. From within your TaxAct return (Online or Desktop), click on the Federal tab. On smaller devices, click the menu icon in the upper left-hand corner, then select Federal 
  2. Click Itemized or Standard Deductions to expand the category and then click Taxes paid
  3. Enter the adjusted amount in the field Prior Year State and Local Estimates Paid After 12/31/2014

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