J.K. Lasser's Your Income Tax 2013: For Preparing Your 2012 Tax Return

11.5 Refunds of State and Local Income Tax Deductions

A refund of state or local income tax is not taxable if you did not previously claim the tax as an itemized deduction in a prior year. For example, if you claimed the standard deduction on your 2011 return and in 2012 you received a refund for state tax withheld from your 2011 wages, the refund is not taxable on your 2012 return.

Refund of deduction for state/local income taxes or state/local general sales taxes.

If in 2012 you received a refund for state or local income tax that you claimed as an itemized deduction for a prior year, the taxable portion of the refund depends on the amount of the state/local general sales tax that you could have deducted in lieu of the state/local income tax (16.3). In general, the full amount of the refund is taxable for 2012 if it is less than the excess of the state/local income tax claimed as a deduction in the prior year over the state/local general sales tax that you could have but did not deduct. If the refund is more than the excess, the amount subject to tax is limited to the excess. For example, on your 2011 return, you claimed an itemized deduction for $11,000 in state/local income taxes, as this exceeded your payment of $10,000 in state/local general sales taxes. If in 2012 you received a $750 refund of 2011 state income tax, the entire refund would be taxable, since it is less than the $1,000 excess of the state/local income taxes over the state/local general sales taxes for 2011. ...