The Claim of Right
Cash basis taxpayers include amounts in gross income in the tax year received. If they must pay back the income amount in a later tax year, a deduction OR a tax credit may be allowed in the year of repayment--thus, the return for the year the income was originally claimed is not amended. However, return data from that previous tax year may be needed in order to compute the repayment year deduction or tax credit (whether to claim a deduction or credit, or for years 2018-2025 if certain deductions can be claimed, depends on which method produces the lower tax AND the amount of the repayment).
Claim Of Right Doctrine
Code Section 1341 describes the Claim of Right doctrine which offers benefits to taxpayers who have included an amount in income in one tax year but have had to repay all or part of it in a later year.
Transactions Covered by The Doctrine
The doctrine can apply to most any type of transaction in which a taxpayer receives income, other than one involving sale of inventory. Thus, required repayments of wages, commissions, alimony, social security, capital gain income, etc., can all be covered by the claim of right provisions.
Deduction vs. Tax Credit in the Repayment Year
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Repayments of $3,000 or less – If the amount repaid is $3,000 or less, deduct it from the taxpayer’s income in the year the taxpayer repaid it. The repayment is generally deducted on the same form or schedule on which the income was previously reported. For example, if it was reported as self-employment income, deduct it as a business expense on Schedule C (Form 1040) or Schedule F (Form 1040). If reported as a capital gain, deduct it as a capital loss on Form 8949 (1040 Schedule D). If reported as wages, unemployment compensation, or other non-business income, report it as a Schedule A Tier 2 miscellaneous itemized deduction. However, Tier 2 miscellaneous itemized deductions (those subject to the 2% of AGI reduction) are suspended by the TCJA for 2018 through 2025. Therefore, during this period taxpayers making repayments of $3,000 or less that aren’t related to a business or capital transaction are effectively prohibited from deducting these payments.
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Repayments over $3,000 (no change by TCJA) - If the amount repaid was more than $3,000, the taxpayer can deduct the repayment as explained above (except as a Tier 1 (no 2% of AGI reduction) miscellaneous deduction if itemizing deductions) OR as a tax credit based on the difference in tax with or without the repaid income in the year the income was originally reported. Make both computations and select the one that provides the greater benefit.