For itemizers, it’s one of the stranger parts of the tax code. First you get to take a deduction of your state and local taxes, then all of a sudden the next year you get a 1099-G from your state and you’re paying taxes on your state and local tax refunds. What gives?
There are times when your state and local tax refund is not taxable, though, and we’ll cover that first.
In general, if you didn’t deduct state and local income taxes last year, you don’t need to pay taxes on your state and local tax refund this year. For instance, if you didn’t itemize your deductions last year (you took the standard deduction) then your state tax refund is tax free this year.
Also, if you were able to deduct your sales tax and not your state income taxes on last year’s return, then your state refund is not taxable when you file this year.
If you deducted your state and local income taxes last year and received a state tax refund last year then your total state tax refund that you received from the previous year may be taxable. TurboTax will ask you simple questions about your previous year state tax refund if you deducted state taxes last year and will perform calculations to determine how much of that refund is taxable based on your answers.