 Income tax 2023-2024. Tax refunds, credits or offsets of state and local income taxes. Get ready and some coffee so we can recognize the code cracks when doing income tax preparation 2023-2024. Most of this information can be found in the Instructions for Schedule 1 section of the Form 1040 Instructions Tax Year 2023, which you can find at the IRS website, iris.gov, iris.gov. Looking at the income tax formula, we're focused online. One income. Remember in the first half of the income tax formula, it's kind of a funny income statement. Most income statements having income minus expenses resulting in net income. Here we have income minus various deductions result in taxable income. Noting that the income line item is something that we would generally like to have as low as possible for taxes as opposed to as high as possible. So we're looking for items that might be able to be excluded from income. Also noting that some income items might be having a more favorable tax rate other than ordinary income rates such as, for example, the qualified dividends and possibly long-term capital gains. Here's page 1 of the Form 1040. We're in the income section looking at line 8, which is additional income from Schedule 1. So now we have this separate schedule, this looking similar to our Excel worksheet, where when we have more complex situations, we're just going to attach more schedules, which makes sense. So then we go to Schedule 1, Additional Income and Adjustments. We're in Part 1, the Additional Income portion. Line 1, where we have the taxable refunds, credit, or offset of state and local income taxes. Alright, so line 1. First, a word from our sponsor. Yeah, actually we're sponsoring ourselves on this one because apparently the merchandisers, they don't want to be seen with us. But that's okay, whatever, because our merchandise is better than their stupid stuff anyways. Like our Crunchy Numbers is my cardio product line. Now, I'm not saying that subscribing to this channel, Crunchy Numbers with us, will make you thin, fit, and healthy or anything. However, it does seem like it worked for her. Just saying. So, subscribe, hit the bell thing and buy some merchandise so you can make the world a better place by sharing your Accounting Instruction Exercise routine. If you would like a commercial free experience, consider subscribing to our website at accountinginstruction.com or accountinginstruction.thinkific.com, taxable refunds, credit, or offset of state and local taxes. Tip, none of your refund is taxable if in the year you paid the tax, you either A, didn't itemize deductions or B, elected to deduct state and local general sales tax instead of state and local income taxes. Okay, so this is an income line item that seems like it should be fairly straightforward and easy, but is actually quite complex or can be quite complex in certain situations. It's also one of those things, if it is complex or when it is complex, it's useful to have the same software from the prior year rolling over to the current year so the software can help you with those inter-year kind of complex situations, this possibly being one of those. I'll discuss that in more detail in a second. So when we talk about the federal income taxes, that's what we're calculating on the form 1040. If you get a refund from the federal income taxes, that means that you're going to get the refund in the following year. So on the federal tax side of things, if we do the taxes in 2023 and we calculate a refund, we're going to get a refund in 2024. Do you have to include the refund for federal income taxes on your 2024 income tax return? You would think, no, you typically would not. Why? Because it's a refund. It's a refund that you overpaid in the prior year. It's not actually income. You overpaid the taxes and now they're paying back to you. That makes sense from a federal income tax situation, but when you get to state taxes, it gets a little bit more complex because it's possible. You might be able to deduct the state taxes on the federal income taxes generally as an itemized deduction. So then if you allow a deduction for state taxes for federal income tax purposes, then there would be an incentive to try to increase the size of the state taxes that you have, possibly overpaying your state taxes, and then when you get a refund of the tax in the following year, if you don't have to include it in income, that would be one way that you can distort your tax bill. You could try to overpay your state taxes, deduct more in the year that you pay it, and then when you get the refund in the following year, if you didn't have to include it in income, then that would be kind of like a loophole strategy in the law. So that's the problem. Now note, from just a legal standpoint, it would kind of make sense that the federal government had never included state taxes as a deduction, but they're already in place and once they are in place, then you can't really take the state taxes out because it really adjusts everything else. Everybody has done their tax planning dependent on these state taxes. In other words, by including state taxes as something deductible for the federal income tax side of things, the federal government has kind of influenced the way taxes are going to be applied in each of the states because the states might try to take advantage of that, possibly by adjusting their taxes to maximize the federal income tax deduction and so on and so forth. So a few years ago, they actually tried to cap the state taxes that might be taken for federal income tax purposes and that was basically a big issue and a big change because some states have much higher taxes and frankly are much less efficient in utilizing their tax dollars than other states. And those are the ones that are typically going to be hit high cost of living states are typically going to be the ones also that are going to have issues or higher possible deductible state taxes. Now the state tax issue is also something that will typically have an impact on higher income individuals. Why? Because if you get to deduct the state taxes, it's usually going to be deducted as an itemized deduction and therefore only people that itemize are usually going to get that benefit and then have to deal with the possible issue of the refund of the state taxes in the following year and partially due to again some of the changes and attempts to simplify the tax code a few years ago, less people are taking itemized deductions than the standard deductions because the standard deductions have been increased. So as a general practical rule, if you're picking up a new client, for example, and you're looking at the state tax refund that they have received, you're going to ask the question, well, did they get a tax benefit in the prior year? And typically they would only get a tax benefit if they took itemized deductions because the deduction for state taxes is an itemized deduction. If they didn't itemize in the prior year, then even though you're going to get this form saying that you got state taxes, you might not have to include it as actual income because they didn't get a tax benefit from it in the prior year. Now the issue is if they did get a tax benefit from it, it's actually somewhat complex as to how much of a benefit they got from it because if the state taxes was the thing that pushed them up from itemizing to taking the standard deduction, they might not have got the full benefit of all the state taxes but only part of the state taxes and that's where the software comes into play. That's when you might want to say, okay, if this is a new client, I'm going to enter the tax return in the prior software and let the software roll over to the current software so it can properly calculate these roll over items such as the possibility of having state taxes included in income in the current year. Now I also have to just point out now that we're talking about state taxes that there was another issue with state taxes in terms of how the states are calculating or applying their taxes. Remember that the federal government primarily responsible for defense, the military in general classically, and the states are responsible for their well-being on the state side of things such as the police fire department and that kind of stuff. On the state side, on the federal side, we have a federal income tax. On the state side, they could decide to have a different type of tax. They might say that a sales tax, for example, works better on the state side of things. However, if the federal government says that we're going to allow a deduction of state taxes, if they are income taxes and not sales tax, you can see how that will influence the way the states will apply their taxes. That basically means the federal government is mandating an income tax to the states, otherwise they're going to have a huge disadvantage in terms of a deduction, and so they had to change that too. So now you've got this issue of the ability to make deductions, whether you have a sales tax or an income tax, when you think about the itemized deductions, which again adds to a more complexity with regards to the taxation and the refund situation. All right, that said, if you receive a refund, credit or offset of state or local income taxes in 2023, you may be required to report this amount. If you didn't receive a Form 1099G, check with the government agency that made the payment to you. So if, for example, you had an income tax in the state that in the prior year, in 2022, you had an income tax that you paid and you overpaid it, then you will typically get a 1099G, for example, that is going to be basically reporting the refund to you. Normally, when you get a 1099G, that means that you have income that you have to report in the current year, but in this case, it's not necessarily the case that you have to report it as income because you only have to report it as income if you got a tax benefit from paying it in the prior year. Okay, so your 2023 Form 1099G may have been made available to you only in an electronic format, and you will need to get instructions from the agency to retrieve this document. Report any taxable refund you received, even if you didn't receive Form 1099G. So if you're using the same tax software last year as the current year, then hopefully last year's software will help you to determine how much refunds you would get on the state side and the federal side if your state had a state tax. And then when you get the 1099G, that should hopefully give you confirmation about that when you roll it over into the current year, and then your software hopefully will help to determine if you got a tax benefit from it last year and therefore whether you have to report it in the current year. However, note that sometimes there's adjustments that get made. So if you have something different in your software than it says on the 1099G, then you got to make sure that you make an adjustment for that change because the 1099G is of course what is going to be given from the state government to the federal government, and that's what they're going to have on their side when they check our return. So if you choose to apply part or all of the refund to your 2023 estimated state or local income taxes, the amount applied is treated as received in 2023. If the refund, so in other words, let's say you did your state taxes and you had $1,000 refund from the state, not the federal from the state. Now you could say give me the refund and they would send you a track check or electronic deposit it into your account at some point. So in 2022, we're going to say that you did the taxes, you got a refund, and then they give it to you in your bank account. Now you might say I'm not going to take the $1,000, but I'm going to leave it to the state. You keep it state. Why? Because I want you to apply it to the 2023 tax return as part of my estimated payment, as part of my payments. Well then of course you still basically receive the money and then paid it back. That would be equivalent to the state giving you the money and then you gave it back to them as a prepayment for taxes in 2023. So you're still in the same kind of situation as though you got the money to determine whether or not you have to include it in income for federal income tax purposes. So if the refund was for a tax you paid in 2022 and you deducted state and local income taxes on your 2022 Schedule A, itemized deductions, use the state and local income tax refund worksheet in these instructions to see if any of your refund is taxable. Exception, see itemized deduction, recoveries and publication 525 instead of using the state and local income tax refund worksheet and these instructions if any of the following apply. So in other words, this would be the normal worksheet is going to be easier. But if you have these exceptions, you got to use a different worksheet because you have a bit more complex situation. One, you've received a refund in 2023 that is for a tax year other than 2022. So that of course complicates the situation a little bit more because normally if you do your taxes on time, then you would have done your taxes for 2022 and the refund that you would get from the state tax happens in 2023. But what if you didn't file taxes for like three years and then you file three years of taxes 2022, 2021, 2020 and then you've got the refund from all of them in 2023. Well, now that could that could complicate the situation as well. So you might have to dig into that in a little bit more detail. Number two, you've received a refund other than an income tax refund such as a general sales tax or real property tax refund in 2023 of an amount deducted or credit claim in an earlier year. So note that the federal income tax is kind of structured to fit most closely with a state that has a state income tax, right? But states should be sovereign to do whatever they want. Maybe they don't think the income tax is the best way to go and they want a sales tax or some kind of usage tax. Well then the federal government shouldn't be mandating that the state uses an income tax by giving them a tax burden, a detriment on the tax return. So now you have this situation where you have to deal with the if you got a tax benefit for some other tax like a sales tax or something and you got to deduct it. Then then you have a similar kind of situation if there was like a refund in 2023 that you might have to include an income. So this is why they shouldn't have made the state tax deductible in the first place because this is just a mess. Why did they do that for crying out loud? It's ridiculous. Anyway, number three, you had taxable income on your 2022 form 1040 or 1040 SR line 15, but no tax on your form 1040 or 1040 SR line 16 because of the 0% tax rate on net capital gain and qualified dividends in certain situations. Number four, your 2022 state and local income tax refund is more than your 2022 state and local income tax deduction minus the amount you could have deducted as your 2022 state and local general sales tax. Number five, you made your last payment of 2022 estimated state or local income tax in 2023. So that gets into this crossover kind of situation because normally when you pay the taxes, you're on a cashed based system. So if you paid the taxes for tax year 2022, usually if you have a W2 income, you paid them in 2022 because they were taken out of your wages by your employer for example. But it's possible that you made estimated tax payments and you made some of the payments that are applied to 2022 in 2023, which complicates the cutoff dates. And so that can complicate the calculation. Number six, you owed alternative minimum tax. So alternative minimum tax obviously also complicates situations as well. Number seven, you couldn't use the full amount of the credits you were entitled in 2022 because of the total credits were more than the amount shown on your 2022 form 1040 or 1040 SR line 16. Number eight, you could be claimed as a dependent by someone else in 2022. Number nine, you received a refund because of a jointly filed state or local income tax return, but you aren't filing a joint 2023 form 1040 or 1040 SR with the same person. So your filing status changed and that's going to complicate things. So the general rule for the state tax is you're going to get a 1099 for it typically. And the question is, do you include it in income or not? Now, if you got a tax benefit in the prior year, then you might have to include it in income. You would only have a tax benefit if in the prior year you itemized. If you didn't itemize, then it's straightforward and you didn't get a tax benefit easy. You don't have to include it in income, although that's confusing to a lot of people because they get the 1099 and they feel like they should have included it because they got a 1099 for it. But that's the rationale for it. Now, if you have a more complex return where they did deduct it in the prior year, then it gets kind of messy because you have to determine how much benefit they actually got from the deduction. And the tax software is very useful to do that. Therefore, even if you have a new client, I would suggest in a more complex situation what you want to do is not just start doing the data input in the current year 2023, but rather re-input the data in the prior year, which could cost you more money but possibly get you off on the right foot so that then you can roll over the data into the current year. So these roll over things such as itemized deductions, state tax deductions and the benefits you got from it in the prior year will be helped by the software to help you to calculate it and then you can deconstruct it making sure that it's doing the proper thing and that you understand why it's doing what it's doing.