Question: I received a state tax refund last year. Must I include that amount as income on my federal return this year?
Answer :

It depends on several factors, the most important of which is whether you itemized deductions on your federal income tax return last year. If you did not itemize deductions on your federal tax return last year, do not report any of the refund as income.

However, if you itemized deductions last year and then received a refund of state or local taxes, you may have to include all or part of the refund as income on your return this year. In general, state and local income tax refunds are taxable if the refunded tax was deducted in a prior year and you received a tax benefit from the deduction. Refunds are partially taxable if your itemized deductions last year exceeded your standard deduction by less than the amount of the refund.

Complete the state and local income tax refund worksheet found in the instruction booklet to your Form 1040 to determine how much (if any) of your state or local income tax refund is taxable this year.