If a taxpayer received a state income tax refund, what action must they take to determine its tax treatment?

To determine the tax treatment of a state income tax refund, the taxpayer must check if they received a tax benefit for that refund in the previous year. The rationale behind this is based on the tax benefit rule, which states that a taxpayer only needs to report a refund as income if they previously deducted the state income tax that is being refunded. If the taxpayer did not benefit from the deduction in the prior year—meaning that they did not itemize deductions or their state tax deduction did not lower their taxable income—then the refund is not taxable.

In practice, a taxpayer should look back at their prior year tax return to determine whether they actually received a tax benefit from deducting state income taxes. This involves assessing whether they took the standard deduction or itemized their deductions. If the state tax refund did not provide a benefit, it would typically not be included in the taxpayer's income for the current year.

This understanding is crucial because it affects how the taxpayer will report their income, potentially influencing their overall tax liability.