Clark filed Form 1040EZ for the 2011 taxable year. In July
2012, Clark received a state income tax refund of $900, plus interest
of $10, for overpayment of 2011 state income tax. What
amount of the state tax refund and interest is taxable in Clark’s
2012 federal income tax return?

(b) The requirement is to determine the amount of
interest for overpayment of 2011 state income tax and state income
tax refund that is taxable in Clark’s 2012 federal income tax
return. The $10 of interest income on the tax refund is taxable
and must be included in gross income. On the other hand, a state
income tax refund is included in gross income under the “tax
benefit rule” only if the refunded amount was deducted in a prior
year and the deduction provided a benefit because it reduced the
taxpayer’s federal income tax. The payment of state income taxes
will not result in a “benefit” if an individual does not itemize deductions,
or is subject to the alternative minimum tax for the year
the taxes are paid. Individuals who file Form 1040EZ are not
allowed to itemize deductions and must use the standard deduction.
Since state income taxes are only allowed as an itemized
deduction and Clark did not itemize for 2011 (he used Form
1040EZ), his $900 state income tax refund is nontaxable and is
excluded from gross income.