 Hello, and welcome to the session. This is Professor Farhad in which we would look at an example of the tax benefit rule and explain this concept that many students find difficulty with it either when they're studying for their CPA exam or when they are still accounting students in college. Matter of fact, this question was sent by one of my subscribers to clarify a point. So I thought, why not? I would like to share it with everyone else. This way, we can all benefit, especially people who are studying for the CPA exam. So this is basically part of the tax benefit rule. So we have a couple, LA and Pola Files, Emerit, the taxpayer. In August of this year, they received the refund for 5,200 for their state income tax they paid last year. That's fine. It means they overpaid their taxes. The question is how much of the refund, if any, must they include under gross income under the following independent scenario, assuming the standard deduction last year was 24,000? Simply put, they filed the return last year. This is last year. And this is this year. This year, they received the refund of 5,200. The question is, should they include this refund in their income taxes for this year or should they ignore it? Well, it all depends on what happened last year, the prior year. Well, what do we need to know? We need to know if they had any benefit when they paid their state income taxes last year. They overpaid it. Did they get a deduction for that 5,200 on their return last year? If they did and they get a refund this year, then they will have to include it. But let's take a look at separate scenarios, but this is the basic idea. So last year, they had an itemized deduction of 19,200. So simply put, we have to compare two numbers. I'll ask you this. The standard deduction, it's given to us as 24,000 and they had itemized deduction of 19,200. What do you think this taxpayer did? Do you think they took the itemized deduction or do you think they took the standard deduction? Of course, they took the standard deduction. Therefore, whatever they paid last year in state taxes, whatever they paid, did not benefit them. Well, if it did not benefit them, so should they include anything in this refund in their taxable year and this taxable year? And the answer is no. So simply put, for Assumption A, none of the 5,200 is taxable because they could not itemized their state refund. So they did not get a benefit last year. Therefore, they don't include that money in their income. Scenario B. Last year, they claimed itemized deduction of 30,300. Well, the standard deduction is how much? 24,000. What do you think they did last year? Well, obviously, last year, they took advantage of their various itemized deduction and they did not use the standard deduction. Why? Because their itemized deduction is 30,300. Now we have to find out whether the 5,200 is taxable or not. It could be taxable now because when they paid their income taxes, remember, when they computed or their itemized deduction, what's included here is that 5,200 overpayment. Now they received this money back. So they included it last year as a deduction. Now they have it, they basically, they gave them back the money. What is the general rule when this happens? The general rule is this. You would look at your refund. So you'll have to choose between two figures. You would look at your refund. So your refund, well, let me just, you would look at this. You would look at the lesser of your refund, the lesser of your refund or the itemized deduction, itemized deduction, that's a greater than the standard deduction. Greater than the standard deduction. Why? Because that itemized deduction, that's a greater is what gave you the benefit. Let's take a look at the rules here. What is your refund? Your refund here is 5,200. What is your access? What is the amount that is in addition? It's above your standard deduction. Look, 30,300 is your itemized deduction and your standard deduction is 24,000. Let's do the computation here and see what was the access of these two. 30,300 minus 24,000, you benefited it, you benefited 6,300. So guess what? You are going to include the full amount, 5,200 in your income. Why? Because last year, you took this 5,200 as a deduction. Well, in fact, what we find out in August, this was not a true deduction. What happened? The state gave it back to you. Think about it. I want you to logically think about it. What happened is this. What I would do every year, so I don't pay taxes, I will overpay my state taxes. And by overpaying my state taxes, I would claim those itemized deduction. And I would reduce my tax bill, my federal tax bill. But if I overpaid and I get the money later next year, then I'll have to include that refund because I overpaid my taxes in my taxes. If I don't include it, if the rule is you don't have to include any state refund, well, you don't have to if you did not itemize. But if you itemize, you had the benefit last year by doing so. But you really did not owe the state that much because they gave you a refund. So you overpaid. This happens all the time. I'm sure you get a refund. The reason you get a refund is because you overpaid your taxes. And individuals sometimes overpaid their taxes. So if you overpaid your taxes and you get a deduction, if you receive a refund, guess what, that refund is taxable. But if you don't itemize like in scenario A, if you didn't get a benefit, your refund is not taxable because it did not really give you an advantage. Okay, let's take a look at the third scenario. In this scenario, basically, I just have to be aware of certain rules here. Last year, the couple claimed itemized deduction of $26,500. So they claim itemized deduction of $26,500. Their itemized deduction included state income taxes paid of $10,500, which were limited to $10,000. So simply put, they paid $10,500 in actual state income taxes, but they were limited to $10,000 because the new Tax Cuts and Jobs Act, they would limit you to $10,000 due to the cap on state and local income tax deduction. Now, the standard deduction is still $24,000. So what do we have to do under those circumstances? Simply the same rules with a slight modification. What's included in your taxable income is the lesser of your refund minus here, what we have to do, we have to subtract this additional $500 that you could not deduct. You could not deduct it, but you actually paid it to the state, but you could not deduct it. Therefore, this first column will have the number is $4,700. Why? Again, you did get $5,200, but in reality, you paid $500 that you could not use. So your refund is, in quote, $4,600, and you'll compare this to the itemized deduction that's in access of your standard deduction, which is $26,500 minus $2400 is $2,500. What does that mean? It means you include in your income the lesser of $4,700 or $2,500. The lesser is $2,500. Therefore, what's included in your taxable income, $2,500. Always, I'm going to remind you to visit my website, farhatlactures.com, especially if you're studying for your CPA exam or you are taken, obviously, an income tax course, it will help you tremendously. The CPA exam is a lifetime investment in your career. Take it seriously. Don't short change yourself. It's an investment of 30 to 40 years. Good luck, study hard, and of course, stay safe.