Federal tax status of Colorado’s TABOR refunds is again up in the air

The Internal Revenue Service has again raised the possibility that some taxpayers will need to report Colorado’s state tax refunds as income on their federal returns — and that money could be taxed.

Colorado officials are still sussing out what the new guidance, issued Wednesday, will mean for taxpayers who receive refunds of excessive tax collections through the Taxpayer’s Bill of Rights, or TABOR. It’s not the first time they’ve differed with the IRS.

But Gov. Jared Polis called the federal agency’s new view “absurd,” saying in a statement that it could “cost Coloradans money and confuse people, and I call on the Biden administration to reverse course.”

After receiving record rebates in 2022 — $750 per taxpayer — Coloradans can expect hundreds of dollars in refunds again this upcoming tax season, according to nonpartisan state economists.

“The (Colorado) Department of Revenue is still analyzing the impacts of the IRS decision made today impacting the taxability of TABOR refunds,” agency spokesperson Daniel Carr said in a statement. “The Department will need some time to consider the broader implications of the decisions and will issue a clarifying statement at the time.”

Under the new IRS guidance, taxpayers who itemize their federal deductions, including state taxes they paid, and then receive a state tax refund would need to include the refund as income. But that stipulation wouldn’t apply to all taxpayers because of a limit on itemized deductions, the IRS says.

“Most taxpayers receiving state tax refunds do not have to include the state tax refund in income for federal tax purposes,” the agency said in a news release about the guidance. “As a general rule, taxpayers who choose the standard deduction on their federal income tax returns do not owe federal income tax on state tax refunds.”

The IRS asked for comments on the proposed rules and input on how it should treat state sales tax refunds — a pool that Colorado’s refunds draw from heavily. But it otherwise downplayed the potential impact.

TABOR, a state constitutional amendment, limits how much tax revenue the state can collect and requires the state to refund excess collections. The money generally comes from excess sales and income taxes. It’s typically rebated on a tiered system in which higher-income taxpayers receive a higher amount on the idea that they paid more taxes.

However, Democrats at the State Capitol have given preference to flat refunds in recent years, or equal shares for all taxpayers — meaning lower-income Coloradans get more back, and higher-income earners less, than they would under the old tiered system. Democrats have even tied equal TABOR distributions to the passage of Proposition HH, which is on the ballot in November.

Colorado’s tax rebate program has been in place since voters approved the TABOR amendment three decades ago. Refunds reached a record high in 2022.

The extra IRS attention to state refunds came as several other states instituted some form of financial aid to residents in the fallout of the COVID-19 pandemic. It wasn’t clear Wednesday how, or even if, Colorado’s program would be affected by the new IRS guidance.

If new rules do apply, they likely would come into play for the 2024 tax season.

The new guidance incensed Polis. It’s the second time this year the IRS has threatened to tap into TABOR refunds in some way.

“The IRS is proposing going back on thirty years of not treating TABOR refunds as taxable income,” Polis’ statement said. “Our administration strongly disagrees with the IRS guidance as it fails to factor in that TABOR refunds are returning sales tax dollars in addition to income tax dollars and fees that our citizens have already paid” — making it all “an entirely legitimate tax refund” that shouldn’t be taxed.

In February, the IRS briefly asked Coloradans to hold off on filing their tax returns as it considered how to treat 2022’s flat refunds.

After an outcry from the state’s federal delegation and Polis, the IRS backtracked and said it would not tax last year’s refunds.

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