Question

In December 2017, Edward, a cash basis taxpayer, paid $3,200 fire insurance for the calendar year 2018 on a building he held for rental income. Edward deducted the $3,200 insurance premiums on his 2017 tax return. He had $250,000 of taxable income that year. On June 30, 2018, he sold the building and, as a result, received a $1,600 refund on his fire insurance premiums. Which of the following statements is true?

A) Edward must include the $1,600 refund in his 2017 income.
B) Edward can offset the $1,600 refund against any capital gains on the building sale.
C) Edward does not need to include the $1,600 refund in his income.
D) Edward must include the $1,600 refund in his 2018 income.

Answer 1

The correct answer is that Edward must include the $1,600 refund in his 2018 income, consistent with the tax benefit rule, which states that refunds attributed to deductions taken in previous years are taxable in the year they are received.

Step-by-step explanation:

In December 2017, Edward, a cash basis taxpayer, paid $3,200 for fire insurance for the calendar year 2018 but deducted the premium in his 2017 tax return. Considering he received a $1,600 refund in 2018 upon selling the rental property, the correct answer to the question regarding the treatment of the refund is:

D) Edward must include the $1,600 refund in his 2018 income.

As per the tax benefit rule, if a taxpayer receives a refund for an expense that resulted in a tax benefit in a previous year (in this case the deduction of fire insurance premiums), the refund is included as income in the year it is received.

Therefore, since Edward received the $1,600 refund in 2018, that's the year it should be included in his income. The refund is not connected to capital gains from the sale of the building and thus cannot offset capital gains. Also, since the premium was deducted in 2017, it cannot be included in his 2017 income again, nor is it exempt from being included in his income according to current tax laws.