“Itemized Deductions” … All Good Things Must Come to an End

As the old adage goes all good things must come to an end. This is hard to visualize when it comes to anything that has to do with taxes, but this happens to be the case with itemized deductions. As part of the bipartisan agreements of the 2012 American Tax Relief Act the Pease Rule has been reinstated on itemized deductions and personal exemptions for the individuals the government has labeled as “high income” tax payers.

The rule is as follows, the unprotected itemized deductions are to be reduced by the lessor of the following two amounts:

  • 3% of the amounts by which AGI exceeds the threshold amounts listed above
  • Or 80% of unprotected itemized deductions.

So what does this mean to you???

Named after the congressman who originated the rule, it has been nonexistent the last 11 years thanks to the Bush era tax cuts, but has now reared its ugly head once again. The most basic explanation of the rule is that it limits the amount of itemized deductions for high income earners resulting in roughly a 1% overall increase to your tax rate. The adjusted gross income thresholds for when the phase outs begin are as follows:

  • Married Filing Joint: $300,000
  • Head of Household: $275,000
  • Single: $250,000
  • Married Filing Separately: $150,000

These are the base income levels for the 2013 tax year, but will be adjusted for inflation going forward. An important thing to remember is that these dollar amounts are adjusted gross income (AGI) amounts not taxable income amounts.

There are some itemized deductions protected from the rule and they include: Medical Expenses, which are already subject to 10% of a taxpayer’s adjusted gross income; investment interest expense, which is limited to investment income; and casualty or theft losses, which are also subject to 10% of a taxpayer’s adjusted gross income as well.

The unprotected itemized deductions subject to the rule are the three most common deductions: home mortgage interest, state and local taxes, and charitable deductions.

An example:

You are filing married filing jointly and your AGI is $500,000. Therefore, your AGI is $200,000 above the Pease threshold amounts and your unprotected itemized deductions add up to $50,000. The unprotected itemized deductions would be reduced by the lessor of the 3% rule, $6,000($200,000 x 3%) or the 80% rule, $40,000($50,000×80%), therefore your adjusted unprotected itemized deductions would be $44,000($50,000-$6,000).

The realistic effect of this limitation is that it will increase the rate of tax you pay on income above the thresholds previously state by roughly 1%. A simple way to estimate this additional tax would be that for every $100 dollars above your threshold for your filing situation you are being taxed on $103.

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