Must you include in income an amount you paid and deducted in a previous year and then recovered? This situation often arises in connection with state or local income tax refunds and medical expense reimbursements. The answer depends on whether you received a “tax benefit” when the amount was originally paid. If you didn't, the recovery is tax-free. If you did, then all or part of the recovery will be taxed, depending on the tax benefit you received. This principle is known as the “tax benefit rule.” The idea is: if you didn't benefit through tax savings when the amount was paid, you shouldn't incur a tax cost when it's recovered.

No tax benefit when paid. The simplest case in which the recovery is tax-free arises where you didn't itemize deductions in the year you originally paid the amount. Say you and your spouse paid state income taxes of $2,000 in 2007 but didn't itemize deductions because your total itemized deductions didn't exceed the standard deduction then available. If you receive a state income tax refund in 2008, say, of $800, you don't include any of it in your 2008 income.

Full tax benefit when paid. At the opposite extreme, if every dollar recovered had been deducted when originally paid, the recovery is fully taxable. Suppose, for example, you and your spouse paid $5,000 in state taxes in 2007 and claimed itemized deductions totaling $15,000. If you receive a state tax refund of $1,000 in 2008, you must include it all in your 2008 income. Here, when you paid the “extra” $1,000 to the state in 2007, it increased your deduction on your federal tax return by a full $1,000, from $9,000 to $10,000. Thus, the entire amount recovered had given you a tax benefit when originally paid.

(If your state tax deduction was reduced below what you actually, originally paid in state tax, because the overall limit on itemized deductions applied—for those whose adjusted gross income exceeded $156,400 in 2007—then the calculation of the tax benefit is more complicated, but generally the full refund is still includible in your income in the recovery year.)

Partial tax benefit when paid. In some cases, the amount you recover may be only partially included in income for the year of recovery. This occurs where only part of it resulted in a tax benefit when originally paid.

Example. Tom and Sue filed jointly in 2006. They claimed a total of $11,150 in itemized deductions, which included $3,000 in state income taxes paid. In 2007, they received a state income tax refund of $1,000. If they had not paid this “extra” $1,000 in 2006, their total itemized deductions would have been $10,150. In that event, they would have taken the standard deduction ($10,300) instead of itemizing. Accordingly, the extra $1,000 of state taxes paid in 2006 only increased their deductions by $150: from $10,150 to $10,300. Thus, when they received their $1,000 refund, only $150 of it is taxable.