I’ve been asked about the “Pease Limitation” by a few advisors, mainly from the charitable side. With most of the attention focused on the transfer tax exemptions and rates, income tax rates, and the 3.8% Medicare Tax, this is one of the stealthier provisions of American Taxpayer Relief Act of 2012 (ATRA) impacting high-income earners. Under ATRA, the Pease limitation is reintroduced into the tax law reducing the amount of itemized deductions for certain taxpayers. This is also referred to as the “phaseout of itemized deductions.” While not as severe as the previous Pease limitations, it can greatly limit itemized deductions like mortgage interest and charitable gifts.
The Pease limitation, named after former Congressman Donald Pease, was first incorporated into the tax law in 1990. The purpose of the Pease limitation, or phase-out, was to raise revenue by limiting some common itemized deductions among high-income earners.
Specifically, Pease limitations 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 apply for taxpayers with adjusted gross income (AGI) levels exceeding $300,000 for joint filers and $250,000 for individuals, indexed for inflation. Income over those applicable amounts 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.
For Example: Assume a married couple has an AGI of $500,000 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
Under these facts, option (a) would result in a $6,000 reduction of the couple’s itemized deductions, while option (b) would reduce the couple’s itemized deductions by $36,000.
(a) 3% x $200,000 ($500,000 – $300,000) would reduce the couple’s itemized deductions by $6,000.
(b) 80% x $45,000 would reduce the couple’s itemized deductions by $36,000.
Since option (a)’s $6,000 reduction is the lesser of the two limitations the couple’s itemized deductions would only be reduced by 13% taking their total itemized deductions of $45,000 down to $39,000 ($45,000-$6,000). At a 39.6% marginal tax rate, that equates to a true loss of $2,376 ($6,000 X 39.6%).
The Pease limitation does NOT apply to the following deductions:
- Medical expense deduction;
- Investment interest deduction;
- Casualty or theft deduction; or
- Gambling loss deductions.
However, most of these exempted deductions are not very common or they are difficult to qualify for due to their high AGI hurdles. For example, deductions for medical expenses only apply to qualified medical expenses over 10% of an individual’s AGI in 2013.
While there aren’t many options a typical high-income earning taxpayer can take to avoid the Pease limitation going forward, the following can help reduce the impact:
- Lower “above the line” income through contributions to retirement plans or health savings accounts.
- Refinance or pay down your mortgage to lower the “deductible” amount of interest.
- Prepare multi-year tax projections to determine if spreading deductions over multiple years will minimize the impact of the limitation. For charitable contributions, this may mean it’s now better to give in smaller annual amounts over time, rather than a single, large contribution. Alternatively, use of a charitable remainder or lead trust might be helpful as well.
Each case is fact specific and there is not easy rule of thumb, you just have to do the calculation.
Hope this helps.