I.R.S. Decides Most Special State Payments Are Not Taxable

The Internal Revenue Service said on Friday that most taxpayers who received one-time, state-issued payments last year to alleviate the pain of higher inflation would not need to report them as income on their federal income tax returns. But some taxpayers in four states may need to claim the special payments.

Last week, the agency told taxpayers to hold off on filing their returns until it could provide further guidance on how to treat the payments, which affected millions of people in nearly two dozen states.

The confusion arose because the I.R.S. had to decipher which payments were indeed taxable. Each state that sent checks to residents classified them slightly differently and had different eligibility requirements. Tax preparers and taxpayers were frustrated that the agency hadn’t settled the issue before it started accepting returns on Jan. 23.

Nearly three weeks into filing season, the agency sorted it out.

“The I.R.S. has determined that in the interest of sound tax administration and other factors, taxpayers in many states will not need to report these payments on their 2022 tax return,” it said in a statement on Friday evening. “While in general payments made by states are includable in income for federal tax purposes, there are exceptions that would apply to many of the payments made by states in 2022.”

Disaster and welfare payments are generally not taxable, and the I.R.S. said it determined that payments in 17 states met that definition — and that taxpayers there wouldn’t need to report the payments. Sixteen of those states are California, Colorado, Connecticut, Delaware, Florida, Hawaii, Idaho, Illinois, Indiana, Maine, New Jersey, New Mexico, New York, Oregon, Pennsylvania and Rhode Island. (The agency provided a chart that linked to the state payments that will not be taxable.)

In the 17th, Alaska, dividend payments that are regularly made to residents generally are taxable, but the state’s supplemental energy relief payment will not be.

The situation is a little trickier for taxpayers in Georgia, Massachusetts, South Carolina and Virginia. Taxpayers in those four states who claim the standard deduction will not need to report the state payments as income, but taxpayers who itemize will — if the payment provides an extra tax benefit.

How would a taxpayer get an added benefit? People who itemize receive a federal deduction for taxes paid to state and local governments (including property taxes), also known as the SALT deduction, which is capped at $10,000 annually.

If a taxpayer owed $5,000 in state taxes but received a $500 state refund, that would mean the net payment to the government was only $4,500. But the taxpayer would have reported $5,000 to the federal government for the SALT deduction, which would be overclaiming, explained Jared Walczak, vice president of state projects at the Tax Foundation.

“The solution is to treat the rebate as income,” he said.

The I.R.S. did not immediately say whether taxpayers who had already filed in those states would need to amend their returns to report the state-related income.

The I.R.S. singled out the four states because the payments were issued as “refunds,” which reduce an individual’s tax bill, instead of “rebates,” Mr. Walczak said. But functionally, he said, they were the same.

“It’s hard to understand why, after taking a generous, pro-taxpayer interpretation in most states, they insisted on a more formalistic interpretation in four,” he said.

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