Is the IRS Looking for a State Refund on Your 2005 Federal Return?

Did you receive a letter from the IRS?  Is the IRS saying that you didn’t report your 2004 state refund as income on your 2005 Form 1040, line 10?  Is the IRS telling you to pay more tax now plus interest and penalty?

Did you find your 2005 Form 1040 and check line 10 and it was blank? How could that be?  You know that you entered the 2004 refund into TurboTax 2005. Why isn’t it there?  What are you going to do?  You’re going to take a deep breath and then read this blog. We’re here to help!

For the majority of taxpayers who itemize their deductions, all of their state refund from a prior year is taxable on their federal return the next year. Sometimes that refund is only partly taxable or not taxable at all. For more information read my blog “Is My State Refund Taxable and Why? 

It is not unusual to receive an IRS notice when you itemized your deductions in a prior year yet your state refund is not showing as taxable the next year.  The IRS is just asking for the details of calculations that determined the refund wasn’t taxable.

Here are the steps to take in this situation:

§       Find your “State and Local Income Tax Refund Worksheet “ for 2005

o         Dig out your printed copy of your 2005 tax return  or

o         Launch your  2005 TurboTax product and open your federal tax return   

§          Select Forms (top toolbar)

§          Select Open a Form

§          Scroll down and highlight State Tax Refund Worksheet

§          Click Open

§       On the State and Local Income Tax Refund Worksheet, find line 19.  This is the amount of your 2004 refund, received in 2005, that was taxable on your 2005 Form 1040. If any amount is taxable, it should be on Form 1040, line 10.

§       Send the IRS:

o         A copy of your 2005 Form 1040, pages 1 and 2

o         A copy of the 2005 State and Local Income Tax Refund Worksheet.  Circle line 19 on that worksheet

o         A copy of your 2004 Form 1040, pages 1 and 2 and Schedule A

o         Attach a statement saying how much, if any, of your 2004 tax refund was taxable on your 2005 federal tax return and refer the IRS to the 2005 State and Local Income Tax Refund Worksheet 

If you elected to deduct state and local sales tax instead of state and local income tax on your 2004 Schedule A, your 2004 state refund is not taxable on your 2005 federal tax return. If you receive an IRS letter about your 2004 refund, here are the steps:

§       Send the IRS:

o         A copy of your 2004 Form 1040 and Schedule A. Circle line 5 on your 2004 Schedule A

o         Attach a statement saying that you elected to deduct state and local sales tax in 2004, not state and local income tax. Therefore your 2004 state refund was not taxable on your 2005 tax return.

If receive an IRS letter asking about your state refund and you didn’t itemize deductions (Schedule A) in 2004, do the following: 

§       Send the IRS

o         A copy of your 2004 tax return

o         Attach a statement saying that you didn’t itemize your deductions in 2004 therefore your 2004 state refund was not taxable on your 2005 federal tax return

And that’s it.  And as I often say, “Ain’t taxes fun!”

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