A taxpayer receives a refund of $1,000 in Year 2 for state income taxes paid in Year 1. In Year 1, the taxpayer claimed the standard deduction. How much of the refund is taxable in Year 2?

Answer options:

$1,000

$500

It depends on the taxpayer's marginal rate.

How to approach this question

Tax Benefit Rule: Refunds are income ONLY if the original payment provided a tax benefit (deduction). Standard deduction means no specific benefit from state tax payment.

Full Answer

A.$0✓ Correct

Under the tax benefit rule (IRC §111), a refund of a prior year expense is included in income only to the extent the prior deduction reduced tax liability. Since the taxpayer took the standard deduction in Year 1, they received no tax benefit from the state tax payment, so the refund is not taxable.

Common mistakes

Automatically treating refunds as income.

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