Personal Deductions: Back to the Future

Just as Washington is now scrambling to adopt a budget and new debt ceiling to avert a spending Fiscal Cliff, earlier in the year they enacted new tax legislation to avoid a tax Fiscal Cliff. In addition to changes related to tax rates, they enacted legislation that can have a significant impact on your personal deductions.

A tax law provision that limits the dollar amount of itemized deductions for high-income taxpayers is returning with a vengeance. The so-called “Pease rule” or “Pease amendment” — named for the Congressman who originally introduced it more than 20 years ago — could have a significant impact on your 2013 tax liability.

Under the Pease rule, certain itemized deductions are reduced if your adjusted gross income (AGI) exceeds a specific dollar threshold. The Pease rule was suspended for several years but the American Taxpayer Relief Act officially revived the Pease limitation on itemized deductions.

The Pease rule reduces the total amount of a higher-income taxpayer’s otherwise allowable itemized deductions by three percent of the amount by which the taxpayer’s adjusted gross income exceeds an applicable threshold. However, higher applicable threshold levels apply under the new law:
$300,000 for married couples and surviving spouses
$275,000 for heads of households
$250,000 for unmarried taxpayers
$150,000 for married taxpayers filing separately

However, the amount of itemized deductions is not reduced by more than 80 percent.
Note that the Pease rule does not apply to all itemized deductions, although several “big-ticket items” are on the list. This includes charitable donations, mortgage interest, state and local income taxes and property taxes, and miscellaneous expenses such as employee business expenses. It does not apply to medical expense deductions, investment interest deductions, casualty and theft deductions, or gambling loss deductions, but these other deductions already have built-in limits. For instance, medical expense deductions are generally limited to the excess above 10 percent of your AGI in 2013 (up from 7.5 percent in 2012).

Example 1: Suppose that John exceeds the AGI threshold by $200,000 and has $50,000 in annual deductions from charitable gifts, mortgage interest and state and local taxes. As a result, the reduction is equal to 3 percent of the $200,000 excess, or $6,000. So his itemized deductions of $50,000 are scaled back to $44,000.

Example 2: Now say that Jane exceeds the AGI threshold by $1 million and has $35,000 in annual deductions from charitable gifts, mortgage interest and state and local taxes. Normally, the reduction would be equal to 3 percent of the $1 million excess, or $30,000, cutting back her deductions to only $5,000. But this would be a reduction greater than 80 percent. As a result, the reduction cannot be more than $28,000, so Jane can deduct $7,000.

The American Taxpayer Relief Act also officially revives the personal exemption phase-out rules, but at the same threshold levels as the Pease rule.

Under the phase-out, the total amount of exemptions that may be claimed by taxpayers for themselves and their dependents is reduced by two percent for each $2,500, or portion thereof (two percent for each $1,250 for married couples filing separate returns) by which the taxpayer’s adjusted gross income exceeds the applicable threshold level.

Consider the potential impact of the Pease rule in 2013 and future years. It may encourage you to postpone charitable gifts to a low-tax year or accelerate deductible expenses into this year if you anticipate being below the AGI threshold.

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