Possible Bug Found in IRS Publication 525 Worksheet 2 for Itemized Deduction Recoveries

You've spotted something interesting there. Publication 525's worksheets for handling state tax refunds can definitely be confusing, but they're trying to implement what's called the "tax benefit rule" - you only have to include a recovery in income to the extent you received a tax benefit from it in a prior year. The issue with Worksheet 2a is that it's attempting to account for the SALT cap limitation, which was introduced with the Tax Cuts and Jobs Act. Since the deduction for state and local taxes is now limited to $10,000, not everyone got the full benefit of all the state taxes they paid. If you hit that $10,000 cap, then you're right - not all of your refund should be taxable because part of what you paid never gave you a federal tax benefit in the first place. The worksheet is supposed to help you figure out that proportion, but the calculation can get tricky. Would you mind sharing which specific step in Worksheet 2a you think contains the error? That might help pinpoint if there's truly a flaw or if it's just a matter of interpretation.

After struggling with this exact same issue last year, I found taxr.ai (https://taxr.ai) incredibly helpful for sorting out complicated deduction recovery calculations. I was completely confused by the Pub 525 worksheets and wasn't sure if I was interpreting them correctly, especially with the SALT cap complications. I uploaded my previous year's return and my state refund info to taxr.ai, and it automatically calculated exactly how much of my state refund was actually taxable. It showed me that I was about to overpay by reporting too much of my refund as taxable income, since part of my state taxes had exceeded the SALT cap. The tool breaks down the calculation step-by-step and explains why only a portion of my refund was taxable. It saved me from overpaying and gave me peace of mind that I was handling this correctly.

I wanted to follow up about my experience with taxr.ai after my skeptical comment. I decided to try it with my 2023 taxes since I had a similar situation with state tax refunds and the SALT cap. The tool actually identified that I should only be reporting about 60% of my state refund as taxable income, not the full amount that I was planning to report. What impressed me was how it explained WHY this was the case - showing exactly how the tax benefit rule applied to my specific situation with the SALT limitation. The step-by-step breakdown was much clearer than Publication 525's worksheets, and I could see exactly where the standard worksheet wasn't accounting for my situation correctly. I double-checked the calculation manually and it was spot-on. Ended up saving me from reporting about $900 in additional taxable income. Worth every penny for the peace of mind alone.

For anyone still confused about this worksheet issue, after spending HOURS trying to get someone at the IRS on the phone to explain this, I finally had success using Claimyr (https://claimyr.com). I was skeptical at first, but after watching their demo video (https://youtu.be/_kiP6q8DX5c), I decided to give it a try. I got connected to an IRS agent in about 25 minutes (compared to the 3+ hours I spent on previous attempts without getting through). The agent confirmed there are situations where the worksheet in Publication 525 doesn't handle certain SALT cap scenarios perfectly, especially when you have a mix of different types of state and local taxes. The agent walked me through how to properly calculate the taxable portion of my state tax refund in my specific situation, which was different from what the worksheet was telling me. Apparently, in cases like mine, they recommend working with a tax professional to ensure the tax benefit rule is properly applied rather than following the worksheet strictly.

I need to eat crow on my skeptical comment about Claimyr. After my frustration boiled over trying to get clarification on this exact worksheet issue, I reluctantly tried the service. I fully expected it to be a waste of money or some kind of scam. Well, I was wrong. The service called me back in about 40 minutes with an actual IRS representative on the line. I explained the issue with Publication 525's Worksheet 2a, and the representative acknowledged that the worksheet doesn't handle all SALT cap situations perfectly. She explained that the worksheet was designed before the SALT cap was implemented and hasn't been fully updated to address all edge cases. The agent spent nearly 30 minutes walking me through how to properly calculate my taxable state refund amount based on tax law principles rather than strictly following the worksheet. This saved me from reporting approximately $1,200 in additional taxable income that I shouldn't have had to report. I'm still shocked that this actually worked, but I wanted to share my experience in case others are struggling with this same worksheet issue.

I think I understand the issue you're describing. The problem appears to be how the worksheet allocates the refund between the portion of state taxes that were deductible (under the $10K SALT cap) and the portion that wasn't. The conceptually correct approach should be a proportional allocation. If you paid $15K in state taxes but could only deduct $10K (2/3 of what you paid), then only 2/3 of any refund should be taxable. But the worksheet doesn't seem to do this calculation properly in all cases. I recommend documenting your calculation method with a statement attached to your return if you decide not to follow the worksheet exactly. This creates a record of your reasonable interpretation of the tax benefit rule, which is the underlying principle that should govern this situation.

For those interested in the technical details, I believe the specific issue is in how Worksheet 2a handles the refund allocation. Looking at the latest version, Step 5 has you multiply your refund by a fraction (state/local income tax deducted ÷ total state/local income tax paid). This seems correct conceptually. However, the problem may be in how this interacts with other types of SALT deductions (like property taxes) when you've hit the overall $10K cap. The worksheet doesn't seem to properly account for situations where you've claimed multiple types of SALT deductions that together hit the cap. Has anyone contacted the IRS about this potential issue? It seems like something they should clarify or correct in a future revision of Publication 525.

This is a great discussion that highlights a real problem many taxpayers are facing. I've been dealing with this exact worksheet issue for my 2023 return and it's incredibly frustrating that the IRS hasn't provided clearer guidance. What I found helpful was creating my own calculation spreadsheet that follows the tax benefit rule more precisely. I calculated what percentage of my total state/local tax payments actually provided a federal tax benefit (considering the SALT cap), then applied that same percentage to my refund to determine the taxable portion. For example, if I paid $12,000 in state income tax and $8,000 in property tax ($20,000 total) but could only deduct $10,000 due to the SALT cap, then only 50% of my payments provided a tax benefit. So if I received a $2,000 state income tax refund, only 50% ($1,000) should be taxable income. This approach seems more aligned with the underlying tax principle than blindly following a worksheet that wasn't designed for post-TCJA scenarios. I'm planning to attach a brief explanation with my return showing this calculation method. Has anyone else taken a similar approach, and if so, have you had any issues with the IRS accepting it?