Repayments, Refunds, Rebates, Recoveries, and Taxes

When it comes to taxes, things don’t ways move in one direction. You make a payment, only to receive something back. Or you have income now, only to find you must repay some or all of it. How do you handle the reporting of these transactions on your tax return? Let’s see…

Repayments of income

Suppose you receive income but later must repay it.  For example, let’s say you receive unemployment benefits, which are taxable, but later are required to make a repayment. The tax treatment depends on the timing of the repayment.

If you repay the income in the same year in which you received it, then offset the income by the repaying. In other words, only report the net amount of income.

If you repay the income in a subsequent year, all of the income must be reported in the year of receipt (even if you know before you file the return for the year of receipt that you’ll have to make a repayment). But there are two options for handling the repayment:

• Treat the repayment as a miscellaneous itemized deduction. This is reported on Schedule A of Form 1040 (i.e., you must itemize to deduct the repayment).
• Claim a tax credit in the year of repayment, provided the repayment is more than $3,000.

If the repayment is wages from which Social Security and Medicare taxes (FICA) were withheld, ask your employer for a refund of these taxes. If the employer does not give you a refund, you can seek one from the government by filing IRS Form 842. For the additional 0.9% Medicare tax, the employer cannot refund any excess payment. The only way to recoup it is to file an amended return, Form 1040X, for the year of the payment.

Refunds

If you receive a refund of federal income taxes, it’s tax free to you. There is nothing to report.

If you receive a refund of state and local income taxes, whether you have to pick up any income depends. If you claimed the standard deduction in the year in which you paid the taxes, then a refund is tax free.

If you itemized, only the portion of the refund that gave you a tax benefit is treated as taxable income. The taxable portion is reported on line 10 of Form 1040.

Rebates

Cash rebates from a dealer or manufacturer for an item you for items you buy are tax free. They are viewed in the tax law as merely reducing the purchase price of the item.

Health insurance rebates from insurance companies (also referred to as rebates of the medical loss ratio) may or may not be taxable.

• If no itemized deduction was claimed for the premiums, the rebate is not taxable.
• If an itemized deduction was claimed for the premiums, the rebate to the extent the deduction produced a tax benefit (see recoveries below).
• If a self-employed person deducted the premiums as an adjustment to gross income (i.e., as an “above-the-line deduction”),  then the entire rebate is taxable.

Recoveries

If you claimed a deduction for medical expenses, mortgage interest, casualty and theft losses, or other deductible costs and later receive money back from an insurance company, a lawsuit, a bank, or other source, you must report income. The amount of income is figured under the “tax benefit rule.” This means you pick up the income to the extent that the original deduction gave you a tax benefit.  As in the case of a refund of state and local income tax, if you didn’t itemize, then the insurance recovery isn’t taxable. But if you did itemize, you have to figure the portion of the recovery that represents a tax benefit to you.

A taxable recovery is reported on line 21 as “other income” on Form 1040.

If you receive interest on a recovery, the interest is reported separately as interest income.

Conclusion

With income coming in and out of your bank account, be sure to know whether you need to take any tax action.