The issue of repayment of income arises when you receive some taxable income and it is later determined that you received some of all of the income in error. It doesn't happen that often, but it does happen. Some common examples of income which may have to be repaid are unemployment compensation, social security payments, bonuses and excess compensation.

What are the tax problems caused by repayment of income?

Generally, repayment of income does not cause a tax problem if it is repaid in the same year it was received. It may create a cash flow problem however, because you have already spent the money. A tax problem arises when the previously received income is required to be paid back in a year following the year it was originally received. The proper tax treatment of the payback depends on the amount of income that must be repaid.

If the repayment amount is $3,000 or less, it is reported on your federal tax return on Schedule A - Itemized Deductions. There are two problems with this rule:

First, the repayment is reported on line 22 of federal Schedule A. This makes it subject to the 2% of adjusted gross income limitation, so the deduction for the full repayment will often be reduced, and it is even possible that you will receive no deduction at all for the payback, even though you may have paid income tax on 100% of the amount received.

Second, if you don't itemize in the year of repayment, you receive no benefit at all. In other words, you paid tax on the income, spent it, and must give it back, but you do not get any of the previously paid taxes back. Also, many states, (Michigan is one example) do not allow itemized deductions so you receive no benefit from the payback on your state return.

If the required payback is more than $3,000 there are two different treatment options available:

Your first option is to report the repayment on Schedule A, but on line 27, rather than on line 22. Line 27 deductions are not subject to the 2% of adjusted gross income limitation.

The second option is to take a tax credit on page 2 of the Form 1040. To take the credit you will need to recalculate your federal income tax for the year the income was originally received without including the repayment amount. The credit will then be the difference between the original tax liability and this Corrected tax liability.

Which option is better?

If your taxable income in the year of repayment is greater than the taxable income in the year you originally received the money, and you itemize, the schedule A deduction option would probably be the better option to use. If your taxable income in the year of repayment is less than the original years' taxable income, the credit option will probably be the better option.

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