By: John Pitlosh
One of the impacts from the fiscal cliff legislation which high income earners should be aware is the reintroduction of the Pease limitation. The Pease limitation reduces the amount of itemized deductions that certain tax payers are allowed. While the American Taxpayer Relief Act of 2012 has reduced the impact of the Pease Limitation, it is still around. As a result, high income earners should be aware of the limitation as it can have an impact on 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 was to raise revenue by limiting some popular and common itemized deductions among high income earners. Pease limitations aim to reduce the benefit of the following itemized deductions:
• Charitable Contributions
• Mortgage Interest
• State, Local, and Property Taxes
• Miscellaneous Itemized Deductions
The limitation for 2013 will kick in on AGI levels that exceed $300,000 for joint filers and $250,000 for individuals, indexed for inflation.
Rule: 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.
Example: Assume a married couple has an AGI of $670,000 and the 2013 applicable amount is $300,000. The couple’s 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 $11,100 reduction of the couple’s itemized deductions, while option (b) would reduce the couple’s itemized deductions by $36,000.
(a) 3% x $370,000 ($670,000 – $300,000) would reduce the couple’s itemized deductions by $11,100.
(b) 80% x $45,000 would reduce the couple’s itemized deductions by $36,000.
Since option (a)’s 11,100 reduction is the lesser of the two limitations the couple’s itemized deductions would only be reduced by 25% taking their total itemized deductions of $45,000 down to $33,900 ($45,000-$11,100).
It should be noted that the Pease limitation doesn’t 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 very 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 10% of an individual’s AGI in 2013.3
While there aren’t many practical roads that high income earners can take to avoid the Pease limitation in 2013 and beyond, the following can help reduce the impact:
1. Lower “above the line” income through contributions to retirement plans or health savings accounts.
2. Refinance or pay down your mortgage to lower the “deductible” amount of interest.
3. Have your tax advisor do multi-year tax projections, so you can do a better job of spreading deductions over multiple years to minimize the impact.
While most people are fixated on tax rate increases adding to their income tax bill in 2013 and beyond, very few people are aware that the Pease limitation reinstatement can add to their income tax bills 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 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