Refundable State Tax Credits
Refundable state tax credits must ordinarily be reported as income, the IRS said.
The agency analyzed the tax treatment of a refundable tax credit in Massachusetts in an internal memo in 2012. The memo has a good analysis of the law in the area. It was not made public until June 2014 as ILM 201423020.
Massachusetts offers low-income elderly homeowners and renters a tax credit to help defray the costs of housing. The credit can be claimed by elderly couples who earn up to $60,000 a year $40,000 if single). Any house owned cannot be worth more than $600,000. The credit is capped at $750 a year.
For a homeowner, the credit is the amount of property tax the homeowner pays above 10% of his income for the year. For a renter, 25% of rent is assumed to go for property taxes, so the credit is the amount by which 25% of the annual rent paid exceeds 10% of the renter’s income.
The IRS said there are three general principles for refundable tax credits.
First, cash payments from the state are generally included in income.
Second, government payments do not have to be reported as income if they fall under the general welfare exclusion. However, for a payment to fall under the general welfare exclusion, it should be made from a governmental fund, be for the promotion of general welfare, meaning that recipients are chosen on the basis of need, health, educational background or employment status, and not be made for services that the recipient provides.
Third, a “tax benefit rule” requires anyone receiving a refund of taxes that he or she paid in an earlier year to report the refund as income. However, there is no income to report if the refund is of taxes that were not deducted earlier.
Putting everything together, the IRS said the following about the Massachusetts credit.
A refund to a renter is not taxed under the general welfare exclusion.
A refund to a homeowner who does not claim itemized deductions and, therefore, does not deduct his or her property taxes is not taxed. The payment is from the state government and property taxes are paid in Massachusetts to local governments, but the state and local governments are considered the same for this purpose. Therefore, any tax credit refunded is considered a partial refund of property taxes paid earlier. However, there is no income to report if the taxpayer does not deduct the property taxes he pays.
Finally, a refund to a homeowner who itemizes deductions and deducts property taxes must be reported as income under the tax benefit rule. Reporting the refund as income reverses the earlier deduction for taxes the homeowner did not end up paying in fact.