Claim tax refunds as income on tax return?

Dear Tax Talk,
My husband and I filed amended state (Massachusetts) and federal tax returns for the last three years. It resulted in tax refunds that amounted to $9,000. We also incurred additional taxes that we owe the state ($331). The Internal Revenue Service paid interest on these tax refunds. Will we need to claim these refunds as income on our 2013 return?
— Lisa

Dear Lisa,
There are three separate issues here:

First, federal income tax refunds are not taxable as income.

Second, interest from both the federal and state governments is considered taxable income and should be reported.

Finally, state income tax refunds may be taxable, depending on what you deducted on your prior-year tax returns. If you did not itemize deductions on Schedule A and took the standard deduction, then the state refunds are not taxable. If you did itemize deductions on Schedule A and elected to deduct state and local sales tax instead of deducting state income taxes paid, then the state refunds are not taxable. However, if you itemized your deductions and elected to deduct the state income taxes in an earlier year federal tax return, then generally it must be included in income on your next federal tax Form 1040.

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