How long does Virginia have to recover a refund it paid out by its own mistake, and do I owe interest on the money back?

Plain-English summary

A couple correctly reported their mortgage interest deduction on their 2019 Virginia return. When the Department processed the return, though, it mistakenly recorded a LARGER mortgage-interest deduction than they had claimed -- and paid out a refund based on that inflated number. Roughly two and a half years later, after the IRS flagged a mismatch between the couple's federal itemized deductions and what Virginia had on file, the Department corrected its error and assessed them for the excess refund plus interest. The couple paid the assessment but argued they shouldn't owe interest, since the mistake was the Department's, not theirs.

The Tax Commissioner agreed with them -- but on a different, more powerful ground than the one they raised. Under Virginia Code § 58.1-312, an "erroneous refund" (one a taxpayer wasn't entitled to, caused by the Department's own error) is treated as an underpayment of tax that the Department must assess within two years of the date the refund was issued. Here, the refund went out in June 2020, but the assessment wasn't issued until November 2022 -- more than two years later. Because the Department was outside its own statute of limitations for recovering the money, the entire assessment was abated, and everything the couple had paid (including interest) was refunded back to them.

What this means for you

Anyone who received a refund that turned out to be larger than they claimed

If the Department later tries to recover an inflated refund that resulted from ITS OWN processing error (not something you misreported), check the date the refund was issued against the date of any new assessment. The Department has only two years from the refund date to recover an erroneous refund -- past that, the assessment can be challenged on timeliness grounds alone, regardless of who caused the original mistake.

Accountants and tax professionals

Distinguish an "erroneous refund" recovery (subject to the two-year clock in § 58.1-312) from an ordinary correction of a taxpayer-caused underreporting, which follows different limitations rules. When a client's assessment stems from a refund the Department itself inflated by mistake, calculate the two-year window from the refund issuance date first -- it can resolve the whole dispute without reaching the interest-liability question at all.

Taxpayers worried about owing interest on the Department's own mistake

Under Va. Code § 58.1-1812 B, penalty and interest generally aren't assessed on an erroneous refund if the resulting bill is paid within 30 days of the assessment (interest only starts running from the assessment date itself if you miss that 30-day window) -- but in this case, the taxpayers never had to reach that question, because the assessment itself was already time-barred.

Common questions

Q: How long does Virginia have to recover a refund that was too large because of the Department's own error?
A: Two years from the date the erroneous refund was issued, per Va. Code § 58.1-312 -- an assessment issued after that window is time-barred.

Q: Do I owe interest if the Department overpaid my refund by its own mistake and I later have to pay it back?
A: If you pay the resulting bill within 30 days of the assessment, Va. Code § 58.1-1812 B generally spares you from penalty and interest; if you don't pay within 30 days, interest runs from the date of the assessment (not from the original refund date).

Q: Does it matter that the IRS was the one who tipped off the Department to the mistake?
A: No -- the two-year clock in this ruling runs from when the erroneous refund was issued, regardless of how or when the Department later discovered its own error.

Q: What's the difference between an "erroneous refund" and a normal underreporting correction?
A: An erroneous refund is a refund the taxpayer wasn't entitled to because of a Department processing mistake (defined at 23 VAC 10-110-90 B 7 b); it gets the special two-year assessment limit in § 58.1-312, distinct from other assessment timelines that can apply when a taxpayer underreports income or deductions.

Citations and references

• Va. Code § 58.1-312 (erroneous refund treated as underpayment; two-year assessment limit)
• Va. Code § 58.1-1812 B (penalty/interest treatment of erroneous-refund assessments)
• 23 VAC 10-110-90 B 7 b (definition of "erroneous refund")

Subject

Administration: Erroneous Refund - Statute of Limitations

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 23-57-0

Original ruling text

May 17, 2023

Re: § 58.1 1821 Application: Individual Income Tax

Dear *:

This will reply to your letter in which you appeal an individual income tax assessment issued to *(the “Taxpayers”) for the taxable year ended December 31, 2019.

FACTS

The Taxpayers reported the proper amount of deductible mortgage interest on their 2019 Virginia resident income tax return. When the return was processed, however, the amount of mortgage interest deduction was increased by the Department. As a result, a refund was issued in an amount larger than what the Taxpayers claimed.

Subsequently, the Department received information from the Internal Revenue Service (IRS) indicating that the amount of itemized deductions reported on their federal income tax return did not match the amount the Department had on record, as adjusted. Accordingly, the Department corrected the mortgage interest deduction and issued an assessment to the Taxpayers to recover the excess refund that had been issued plus interest. The Taxpayers paid the assessment but contend they should not have to pay interest because the Department made a mistake in issuing an erroneous refund.

DETERMINATION

Virginia Code § 58.1-312 provides that an erroneous refund is considered to be an underpayment of tax, which may be assessed by the Department within two years from the date the erroneous refund was made. Title 23 of the Virginia Administrative Code (VAC) 10 110 90 B 7 b defines the term “erroneous refund” as the “issuance of refund to which a taxpayer is not entitled.” The regulation further states that “where a taxpayer provides complete and current information and an erroneous refund results from a departmental error, such as a clerical error, the department is limited to recovery within the two year statute of limitations.” Under Virginia Code § 58.1-1812 B, penalty and interest may not be assessed on an erroneous refund, provided that if the bill is paid within 30 days from the date of the bill. If the bill is not paid within 30 days, interest accrues from the date the assessment is issued instead of from the date the erroneous refund was made.

In this case, the Taxpayers reported the correct amount of deductible mortgage interest on their Virginia return. The Department erroneously recorded a different amount of mortgage interest when processing the return, resulting in a greater refund being issued than was reported by the Taxpayers. The refund, however, was issued to the Taxpayers in June 2020. The assessment to recover the refund was issued in November 2022, which is more than two years after the erroneous refund was made. As such, the Department was outside the limitations period for issuing the assessment. Accordingly, the assessment will be abated and the entire amount paid will be issued to the Taxpayers as a refund, including any statutory refund interest.

The Code of Virginia sections and regulation cited are available on-line at www.tax.virginia.gov in the Laws, Rules & Decisions section of the Department’s web site. If you have any questions regarding this determination, you may contact * in the Office of Tax Policy, Appeals and Rulings, at ***.

Sincerely,

Craig M. Burns

Tax Commissioner

AR/4436.B