Although you might have received a Form 1099-G reporting a state or local income tax refund, that isn’t an indication of whether or not the refund is taxable. Generally, if you claimed the state or local income taxes that you paid as an itemized deduction on your previous-year return, then your state or local income tax refund is taxable. However, other circumstances might apply as well. For example, the difference between the itemized deductions that you took last year and the standard deduction for your filing status can reduce the amount of your refund that’s taxable. For more information, see "Other Income" in Publication 17: Your Federal Income Tax.
Example: You're single. On your 2009 federal return, your itemized deductions totaled $6,000, including a $1,230 deduction for the state income tax you paid. As a result of filing your 2009 state tax return, you received a $700 state income tax refund. Since you deducted the state income tax that you paid on your 2009 federal return, the $700 refund that you received will be included in your total income on your 2010 federal tax return. However, only the amount that reduced your 2009 taxable income will be included.
To figure out how much of your refund is taxable in 2010, subtract the standard deduction for your filing status (single) from your itemized deductions total ($6,000). In 2009, the standard deduction for the single filing status was $5,700:
$6,000 (Itemized deductions total) - $5,700 (Standard deduction) = $300
This means that only $300 of your state income tax refund will be included in your total income on your 2010 federal return. If you report your refund income in the State and Local Income Tax Refunds (1099-G) section of the Interview, The H&R Block software will make sure you don't report income that you don't have to.
When deciding whether or not to deduct the state or local income tax you paid on this year’s return, remember that any tax refund you receive might be considered taxable income next year. This is especially important if you expect to get a large state or local income tax refund. In the end, you need to decide whether the tax savings this year is worth the extra tax you might have to pay next year. For more information, see State and Local Income Taxes.