A quick Google search reveals the origin of the derogatory term “Indian giver.” There are various theories of its origin, but one such claim is from author David Wilton in his 2004 book, Word Myths: Debunking Linguistic Urban Legends. He claims that its origin was the result of a misunderstanding of Native American’s system of bartering by the white settlers. He states in his book:
“To an Indian, the giving of gifts was an extension of this system of trade and a gift was expected to be reciprocated with something of equal value. Europeans, upon encountering this practice, misunderstood it, considering it uncouth and impolite. To them, trade was conducted with money and gifts were freely given with nothing expected in return. So this native practice got a bad reputation among the white colonists of North America and the term eventually became a playground insult.”
Eventually this term was commonly heard amongst children as referring to an incident in which one person gives something to another and later demands it back. So what is my purpose of speaking about this you may ask? Is it my intent to offend the many Native American subscribers of the Jewish Link of New Jersey? Certainly not!
One of the more odd tax laws relates to the state tax refund. Let’s say in 2013 you received a nice tax refund from New Jersey in the amount of $1,000. What many people may not realize is that this state refund may be considered taxable income on your 2014 tax return. This seems to make no sense whatsoever. If you itemized your deductions in 2013, one of your tax deductions was probably the state income tax. So first the IRS is “giving” us this tax deduction and now it wants to “take” it back by taxing us on it in 2014? The question is: Is the IRS being an “Indian giver” or does the fault lie on our own misunderstanding, much like the original settlers?
My usual articles make no attempt to give reasons to the tax laws, just merely to help readers understand them and what can be done about it. Using halachic terms, I treat the tax laws as chukim, laws that have no reason known to man, because that’s pretty much how the IRS seems to work. Trying to get into their heads helps about as much as trying to figure out why getting punched in the head hurts so much. All I need to know is that it hurts, and then try and figure out how to avoid it. That’s how most of tax law works; you know the law exists and try to avoid it being so painful. However, in this article, I will explain the ta’amei hamitzvah, the reason for this law, because I feel it may be useful to know. Also it is surprisingly very logical. This can’t be said about too many laws contained in our complex tax code, so let’s commend the IRS this one time.
First, we need to understand when this law is applicable. In general, if (a) you itemized your tax deductions in the previous year and (b) you chose state income tax as one of the deductions as opposed to state sales tax and (c) you received a state refund, then this refund would be included in your income the following year. This obviously does not apply to the seven states where there is no income tax, such as Alaska and Wyoming. (So for all the Jewish Link readers in Anchorage and Cheyenne, this article has zero relevance to you. Nothing to see here. Feel free to skip to Cedar Market’s ad on the back.) Now there are some more complex nuances to this law, such as if you are subject to AMT tax, but for the most part the general rule still stands. However, note that if you used the standard deduction in the previous year or used state sales tax on your itemized deductions, then your refund would not be taxable.
Now for the reason behind the law. The IRS allows taxpayers to deduct state income tax on your federal return. While there are various reasons why this is allowed, this is one of the times it should viewed as a chok. Who cares why it’s allowed, just know that it is. Now, the amount of state and local tax you deduct from your federal return is based on the total amount you paid to your state in estimated taxes and withholding rather than your actual state tax liability for the year. The IRS was generous in allowing a deduction for taxes paid, but this generosity is only extended to the point of your actual tax liability. So, if you end up getting a state refund, in essence you really ended up deducting more on your federal return than you should have and must pay tax on that refunded amount, whereas if you only included the actual state tax liability in your itemized deductions then the refund would not be taxable.
So now that you know the law and you understand the reason, what can you do about it? Firstly, you should know the opposite side of the spectrum, which is any tax liability you paid to a state with your previous year’s tax return is included in your state income taxes paid for the year on your itemized deductions. This is especially important to those in this area who pay both New York and New Jersey taxes and end up getting a refund from New York and have a liability to New Jersey. The net effect may be a wash on your tax return the following year. Secondly, you can plan ahead if you are expecting to a large jump in income in the following year. Paying tax on $1500 in the 25% tax bracket is obviously more than if you are in the 15% tax bracket. So if you expect to be in a higher tax bracket the next year, then you should consider deducting only the amount of state income tax up to your actual state tax liability and no more than that. You will receive less of a tax deduction for this year, but your state refund will be completely tax free in the next year.
Daniel Magence, CPA, Esq. is a principal at Pristine CPA Solutions, LLC (www.pristinecpa.com). Pristine CPA Solutions offers tax and accounting services to individuals and businesses of all sizes. He can be reached at [email protected] or (201)326-6908 if you have any questions, comments or are interested in using Pristine CPA’s services. Its tax season now, so feel free to contact us for a free consultation.
By Daniel Magence
