This is a really complicated but interesting issue. Presumably you included it in income because there was a claim of right to it (i.e. you had the unrestricted right to the money and didn't know you would have to repay it at that time). To deal with this, you need to make a deduction or take a credit the next year. Look at Publication 525 under repayments. The following is from that publication (
http://www.irs.gov/publications/p525...html#d0e8736):
Repayments
If you had to repay an amount that you included in your income in an earlier year, you may be able to deduct the amount repaid from your income for the year in which you repaid it. Or, if the amount you repaid is more than $3,000, you may be able to take a credit against your tax for the year in which you repaid it. Generally, you can claim a deduction or credit only if the repayment qualifies as an expense or loss incurred in your trade or business or in a for-profit transaction.
Type of deduction. The type of deduction you are allowed in the year of repayment depends on the type of income you included in the earlier year. You generally deduct the repayment on the same form or schedule on which you previously reported it as income. For example, if you reported it as self-employment income, deduct it as a business expense on Schedule C or Schedule C-EZ (Form 1040) or Schedule F (Form 1040). If you reported it as a capital gain, deduct it as a capital loss on Schedule D (Form 1040). If you reported it as wages, unemployment compensation, or other nonbusiness income, deduct it as a miscellaneous itemized deduction on Schedule A (Form 1040).
If you repaid social security or equivalent railroad retirement benefits, see Publication 915.
Repayment of $3,000 or less. If the amount you repaid was $3,000 or less, deduct it from your income in the year you repaid it. If you must deduct it as a miscellaneous itemized deduction, enter it on Schedule A (Form 1040), line 22.
Repayment over $3,000. If the amount you repaid was more than $3,000, you can deduct the repayment (as explained earlier under Type of deduction). However, you can choose instead to take a tax credit for the year of repayment if you included the income under a claim of right. This means that at the time you included the income, it appeared that you had an unrestricted right to it. If you qualify for this choice, figure your tax under both methods and compare the results. Use the method (deduction or credit) that results in less tax.
Method 1. Figure your tax for 2005 claiming a deduction for the repaid amount. If you must deduct it as a miscellaneous itemized deduction, enter it on Schedule A (Form 1040), line 27.
Method 2. Figure your tax for 2005 claiming a credit for the repaid amount. Follow these steps.
Figure your tax for 2005 without deducting the repaid amount.
Refigure your tax from the earlier year without including in income the amount you repaid in 2005.
Subtract the tax in (2) from the tax shown on your return for the earlier year. This is the credit.
Subtract the answer in (3) from the tax for 2005 figured without the deduction (step 1).
If method 1 results in less tax, deduct the amount repaid. If method 2 results in less tax, claim the credit figured in (3) above on Form 1040, line 70, and enter “I.R.C. 1341” next to line 70.
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