By: John Pitlosh, CFP®, CPWA®, MST
We can all pray that Congress gets its act together and develops some meaningful long-term tax reform, however high income earners should evaluate their deduction strategies before 2012 is over as the return of Pease limitations in 2013 could limit key itemized deductions like mortgage interest and charitable gifts.
The infamous Pease limitation was first incorporated into the Omnibus Budget Reconciliation Act of 1990 and it is named after former Congressman Donald Pease. The purpose of the Pease limitation is to raise revenue by limiting some popular and common itemized deductions among high income earners. Pease limitations look to reduce the following itemized deductions:
- Charitable Contributions
- Mortgage Interest
- State, Local, and Property Taxes
- Miscellaneous Itemized Deductions
The limitation will kick in on AGI levels that exceed an inflation adjusted applicable amount. The applicable amount back in 1990 was $100,000, but after several years of inflation adjustments the applicable amount is expected to be in the neighborhood of $170,000.
Income over the applicable amount will trigger an itemized deduction limitation that is the lesser of (a) 3% of the adjusted gross income above the applicable amount, or (b) 80% of the amount of the itemized deductions otherwise allowable for the taxable year.1
Example: Assume a married couple has an AGI of $670,000 and the 2013 applicable amount ends up being $170,000. The couples itemized deductions come to a total of $45,000 and they are broken down as follows:
- Mortgage interest deduction – $5,000
- Property tax deduction – $5,000
- State income tax deduction – $20,000
- Charitable deduction – $15,000
Based on the fact pattern and the calculation methods listed above for limiting the itemized deductions, option (a) would result in a $15,000 reduction of the couple’s itemized deductions, while option (b) would reduce the couple’s itemized deductions by $36,000.
(a) 3% x $500,000 ($670,000 – $170,000) would reduce the couples itemized deductions by $15,000.
(b) 80% x $45,000 would reduce the couples itemized deductions by $36,000.
Since option (a)’s 15,000 reduction is the lesser of the two limitations the couples itemized deductions would only be reduced by 33% from the total itemized deductions of $45,000 down to $30,000 ($45,000-$15,000.
It should be noted that the Pease limitation doesnt apply to medical expense deductions, the investment interest deduction, casualty, theft, or gambling loss deductions.2 That said, most of these exempted deductions are not that common or they are difficult to qualify for due to their high AGI hurdles. As an example, deductions for medical expenses only apply to qualified medical expenses over 7.5% of an individual’s AGI.3
Unfortunately for most high income earners, avoiding the Pease limitation in its expected 2013 form will be extremely difficult as there is little that can be practically done to avoid it. It’s not 2013 yet, so there is still time to be proactive and reduce the future impact through:
- Bringing charitable gifts forward into the 2012 tax year either directly or through a donor advised fund.
- Doing Roth Conversions in 2012 to realize income now and reduce future taxable IRA distributions.
- Refinancing your mortgage to a lower interest rate thereby generating less tax deductible interest.
While most people are fixated on new taxes and tax rate increases adding to their income tax bill in 2013 and beyond, very few people are aware of the Pease limitation reinstatement that is already on the books for 2013 and how it too could increase their income tax bill by phasing out some key itemized deductions. Talk with your advisor and tax professional to see how you can better manage the impact of the upcoming 2013 tax changes.
1. IRC 68(a) – Overall Limitation on Itemized Deductions: General rule
2. IRC 68(c) – Overall Limitation on Itemized Deductions: Exception for certain itemized deductions
3. IRC 213(a) – Medical, Dental, Etc., Expenses: Allowance of a deduction