Is state tax refund taxable next year if my itemized deduction was less than what I paid in state tax?

So I'm confused about the whole state tax refund situation for my 2025 taxes. I know that typically state refunds are considered taxable income, but I've got a scenario that's making my head spin. Last year I paid a ton in state taxes according to my W2 - about $10,400. But when I filed using itemized deductions, I could only claim $6,500 for state taxes (stupid MFS $5k SALT cap plus $1,500 in property taxes). My actual state tax bill worked out to be $9,000, so the state sent me a refund of $1,400. My question is - even though I got a refund, I still paid $9,000 in state tax which is more than the $6,500 I was able to deduct on my federal return. So would I still have to claim that $1,400 refund as taxable income for federal taxes next year? It honestly doesn't seem fair if I do since I couldn't even deduct the full amount I paid in the first place! Thanks for any help in figuring this out!

0 coins

18 comments

Sophia Long

•8M

This is a really good question about the taxability of state refunds! The answer depends on what's called the "tax benefit rule." In your case, since you were limited by the SALT cap and couldn't deduct your full state tax payment, you won't have to report the entire refund as taxable income. You'll only need to report the portion of the refund that actually gave you a tax benefit last year. Think of it this way: You paid $10,400, but only got to deduct $6,500 due to the SALT cap. That means $3,900 of your payments gave you no tax benefit. When you got your $1,400 refund, it comes from that "no tax benefit" portion first. Since your "no benefit" amount ($3,900) exceeds your refund ($1,400), your state refund isn't taxable at all on your federal return. If your refund had been larger than the "no benefit" amount, then only the excess would be taxable.

0 coins

Sophia Long

•8M

Yes, that's exactly right! In your example, the person paid $8000 but could only deduct $5000, so $3000 gave them no tax benefit. Their $1000 refund is less than that $3000 "no benefit" amount, so none of the refund would be taxable. The IRS provides a worksheet in Publication 525 under "Recoveries" to help calculate this. Tax software should handle this calculation too if you enter your previous year's information correctly. Just make sure to answer all questions about your prior year state refund accurately when prompted.

0 coins

Logan Greenburg

•8M

I had almost this exact situation last year and was pulling my hair out trying to figure it out. I finally found this super helpful tool at https://taxr.ai that analyzes your previous year and current year returns together to figure out exactly how much (if any) of your state refund is taxable. You just upload your previous year's return and this year's tax documents, and it automatically identifies the "tax benefit" amount. Saved me hours of trying to figure out that worksheet in Pub 525 that the other commenter mentioned. It also created a detailed explanation that I could keep with my tax records in case I ever got audited.

0 coins

Logan Greenburg

•8M

For TurboTax, they do try to handle this calculation but you have to manually enter a lot of information from your prior year return correctly. I found taxr.ai was more thorough because it actually reads both returns together instead of relying on what I input. It definitely explains the calculation step-by-step. It showed me exactly which portion of my state refund was coming from amounts that exceeded the SALT cap (thus not taxable) and which portion (if any) was coming from amounts that had given me a tax benefit. It even cited the specific IRS rules and publications.

0 coins

Lucas Bey

•8M

Wanted to follow up about using taxr.ai that I mentioned in the other comment. I decided to try it despite my initial skepticism, and it was seriously impressive. It showed that NONE of my $2,300 state refund was taxable because of the SALT cap limitation from my previous year. The explanation it provided made so much sense - it showed exactly how much of my state taxes had exceeded the SALT cap and therefore never gave me a federal tax benefit. The report even included references to the relevant tax code sections which I really appreciated. The tool saved me from mistakenly reporting (and paying taxes on) my entire state refund, which I probably would have done without understanding this calculation. Definitely recommend it if you're in a similar situation with the SALT cap.

0 coins

Harper Thompson

•8M

After reading all these comments, I tried calling the IRS to confirm how to handle my similar situation. Spent 3 hours on hold only to be disconnected! Finally used https://claimyr.com (saw it in the YouTube video at https://youtu.be/_kiP6q8DX5c) and got a callback from an actual IRS agent in about 45 minutes. The agent confirmed exactly what others here are saying - if you couldn't deduct all your state taxes because of the SALT cap, then your refund isn't taxable (or is only partially taxable) up to the amount that exceeded the cap. The agent even directed me to the exact worksheet in Publication 525 to use. Getting an official answer from the IRS was worth it for my peace of mind since I was worried about potential audits. No more waiting on hold forever!

0 coins

Harper Thompson

•8M

The service basically holds your place in the IRS phone queue, and when an agent picks up, they connect the call to your phone. You don't have to stay on hold yourself - you just get called when an actual human at the IRS is ready to talk. It's definitely real. I was skeptical at first too - I've been disconnected after waiting on hold with the IRS multiple times. But with this service, I got a callback in about 45 minutes and resolved my question in one call. I don't work for them or anything, just sharing what worked for me after wasting hours trying to get through myself.

0 coins

Jade O'Malley

•8M

I need to apologize for my skeptical comment earlier. After struggling with the IRS hold times for MONTHS about my audit issue, I finally tried Claimyr out of desperation. Got a callback from the IRS in about an hour. The agent was actually really helpful and cleared up my audit confusion plus answered my question about state tax refunds. Turns out I've been incorrectly reporting my state refunds as taxable income for YEARS when they shouldn't have been because of the SALT cap. I might even be able to file amended returns to get some money back. Cannot believe I wasted so much time sitting on hold when this was an option.

0 coins

Hunter Edmunds

•8M

Tax pro here - I see this question a lot. The easiest way to think about it is: 1. How much state tax did you ACTUALLY pay last year? ($9,000 in your case) 2. How much did you get to deduct? ($6,500 in your case) 3. The difference ($2,500) is the amount you got NO tax benefit from 4. If your refund ($1,400) is less than this difference, it's NOT taxable You might need to use the worksheet in Publication 525 if you had other itemized deductions or if the standard deduction comes into play, but for most SALT cap situations, this simplified approach works.

0 coins

Hunter Edmunds

•8M

Yes, your $1,400 refund would be completely non-taxable since it's less than the $3,900 difference between what you paid and what you were able to deduct. And yes, you'll still receive a 1099-G from your state because they don't know your specific federal tax situation. You'll need to report it on your federal return, but the tax software or worksheet will help you calculate that the taxable amount is $0. Don't skip reporting it just because the taxable amount is zero - that can trigger a mismatch notice from the IRS.

0 coins