Question about federal taxation of state refund (US)

Question

I'm doing my 2017 taxes and I've been extremely confused by how federal taxes treat state refunds. Here are the details:

• In 2017 I paid $750 as part of my filing for an extension for my NY 2016 state taxes.
• I then received a $1050 refund for my NY 2016 taxes, in 2017.
• TurboTax says that $980 of my refund is taxable (I think this is the proportion of the refund that was based on tax payments made during 2016)
• The remaining $70 is apparently not taxable because it was based on payments made during 2017, but TurboTax is going to reduce my 2017 state and local deduction by $70 as a result.

I think I understand why state tax refunds are taxable in general (because the refund represents an amount that the federal government didn't get to tax last year, so it makes up for it by taxing it this year). However, I have two other questions:

1. Why divide the refund into two different categories, the refund that was attributable to 2016 payments and the refund that was attributable to 2017 payments? Why not just treat the entire thing as taxable income?

2. Why is the 2017-attributable portion reducing my 2017 state/local deduction? I don't understand why that would happen.

3. On that, it also seems like I could have lost unlimited sums of money (in the form of a reduced state/local tax deduction) by arbitrarily increasing my extension payment. If I increased my extension payment by an extra $500 I would have expected to receive an increased refund of $500, but then TurboTax would have gone ahead and reduced my state/local deduction by some additional amount. I must be missing something, what is it?

Answer 1

The part of the 2016 state tax you paid in 2016 was deductible on your 2016 return, and assuming you did deduct it (i.e. you itemized for 2016, and weren't above the phaseout) you already received the Federal tax benefit of that deduction. The part of your refund attributed to the payments in 2016 is effectively a deduction you took that was more than you were really entitled to, but rather than require you to amend the previous year (which is more complicated for you and more work for them) IRS simply counts it as taxable income for 2017, called 'recovery', and if applicable limited to the part for which you received a tax benefit; see https://taxmap.irs.gov/taxmap/pub17/p17-068.htm and the instructions and worksheet for line 10 in the 1040 instructions downloadable from https://www.irs.gov/forms-instructions .

The payment you made in 2017 is only now being deducted, so you can (and must) make that deduction correct by subtracting the part of the refund attributable to that payment -- i.e. you paid $750 but got back $70, so your net payment (in 2017 for 2016) is only $680. (Presumably you also had withholding and/or estimated payments in 2017 for 2017, and those will also be deductible for 2017 -- without the $10k cap that applies starting in 2018.)

If you had paid 'extra' in the extension payment in 2017 (which to be clear would have foolishly given the state a free 6-month loan), then yes the allocation of the refund between 'recovery of 2016' and 'reduction of 2017' would change, but the total would remain the same. Let's say you paid enough to decrease the first part by $100, and increase the second part by $100, with nothing else different (i.e. you didn't lose any investment income because this money was tied up in the state treasury). Now your deduction is $100 less, but your gross income is also $100 less, so your taxable income is unchanged.