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Tax Benefit Rule

The opposite of Claim of Right is when a deduction from a prior year is recovered, which is covered by the Sec 111 Tax Benefit Rule.

The tax benefit rule states that,if a tax deduction is taken in a prior year and the underlying amount is recovered in a subsequent period, then the underlying amount must be included in gross income in the subsequent period to the extent that amount reduced the taxpayer's tax liability in the prior year. This rule saves you the trouble of having to file an amended tax return for the prior year. The most common recoveries arerefunds, reimbursements, and rebates of itemized deductions.

There are numerous scenarios where this tax rule comes into play. No matter the situation, this simple question needs to be answered: If the refund from the previous year had not been deducted would there have been an increase in the previous year’s tax? If not, then the taxpayer did not receive a benefit and the refund is not taxable. If the taxpayer only received a tax benefit from part of the deduction, then only the portion the taxpayer benefited from is taxable in the current year.

Example – Taxpayer recovers a $3,000 loss that he had written off in his previous year’s tax return. The $3,000 must be included in his gross income reported for the current year. However, if the taxpayer only benefited from $2,000 of the loss in the prior year, then the taxpayer need only include $2,000 in the current year’s income.

IRC Sec 111 describes how to treat the recovery of tax benefit items from prior years that are recovered the current year.

  • Deductions - Gross income does not include income attributable to the recovery during the taxable year of any amount deducted in any prior taxable year to the extent such amount did not reduce the amount of tax imposed by this chapter.
  • Credits – If a credit was allowable with respect to any amount for any prior taxable year, and during the current taxable year there is a downward price adjustment or similar adjustment, the tax imposed for the taxable year shall be increased by the amount of the credit attributable to the adjustment.
  • Exception Where Credit Did Not Reduce Tax – No adjustment shall apply to the extent that the credit allowable for the recovered amount did not reduce the amount of tax in the prior year.
  • Exception for Investment Tax Credit and Foreign Tax Credit – No adjustment shall apply with respect to the credit determined under IRC Sec 46 (primarily a big business credit) and the foreign tax credit. 
  • Treatment of Carryovers - For purposes of this section, an increase in a carryover which has not expired before the beginning of the taxable year in which the recovery or adjustment takes place shall be treated as reducing tax imposed by this chapter.

Where to Report – Generally, recovery of a previously deducted non-business item is reported as other income on Line 8z of Form 1040, Schedule 1, except a recovery of state income taxes previously deducted is reported on Line 1 of Schedule 1.

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