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Don't Be Shocked If Your Tax Deductions Are Slashed

Start with the new top regular tax bracket of 39.6%, mix in a higher maximum tax rate of 20% on long-term capital gains, and then add on the new 3.8% Medicare surtax for certain investors. You can see why you tax bill is likely to be higher. However, when you add in another significant new tax on upper-income individuals, the result could be a real shocker. This new rule, called the Pease Limit, among tax professionals, means that many of the itemized deductions you have used year after year to offset highly taxed income could be reduced. 
Named after Donald Pease, the Ohio member of Congress who proposed it, the Pease rule was included in major tax-cut legislation in 2001 and then was phased out gradually. Now, reinstated by the American Taxpayer Relief Act of 2012 (ATRA), the rule is back with a vengeance. 
The basic premise of the Pease rule is that it kicks in when your adjusted gross income (AGI) for a particular tax year exceeds a specified dollar limit. Under ATRA, the threshold in 2013 is $250,000 of AGI for single filers and $300,000 for joint filers. Those limits will be adjusted for inflation in future years.
If your income exceeds those thresholds, the total of your itemized deductions covered by the rule will be reduced by 3% of the amount above the thresholds, though you’ll never lose more than 80% of what you would otherwise have been able to deduct. Suppose you’re a joint filer in 2013, your AGI is $500,000 and you have $50,000 of itemized deductions affected by the Pease rule. In that case, you’ll lose $6,000 in itemized deductions (3% of your $200,000 of excess AGI), so you’ll be able to deduct only $44,000, not $50,000. 
The 80% cap comes into play for only the wealthiest taxpayers. Let’s look, for instance, at joint filers with $1.8 million of AGI and the same $50,000 in itemized deductions. Normally, the rule would result in a reduction of $45,000 (3% of $1.5 million of excess AGI), but the reduction is limited to $40,000 (80% of $50,000) because of the cap.
Which itemized deductions are covered by the Pease rule? It generally applies to all itemized deductions that aren’t affected by another built-in tax return limit. The rule does apply to deductions for state and local taxes, home mortgage interest, and charitable donations. The Pease rule does not affect deductions for:   
  • Medical and dental expenses;
  • Investment interest expenses;
  • Casualty and theft losses.

However, deductions of miscellaneous expenses, already subject to a 2%-of-AGI floor, are covered by the Pease rule.

This tax law change could make you reconsider a large gift to charity or buying a new car with a hefty sales tax you planned on deducting. But the Pease rule’s bark is often worse than its bite. Let’s go back to our first example of joint filers with an AGI of $500,000 and itemized deductions of $50,000. Suppose they decide to give an extra $10,000 to charity at the end of the year. The reduction of their itemized deductions is still $6,000 (3% of $200,000 excess AGI), letting them deduct $54,000 of their $60,000 in itemized deductions. In other words, that entire $10,000 year-end charitable donation will be deductible.
On the other hand, an increase in AGI at the end of the year may be significant. For example, if the couple with a $500,000 AGI realizes an additional $100,000 in capital gains, their deductions then will be reduced by a total of $9,000 (3% of $300,000 in excess AGI).
The practical effect of all of this will be an increase in the tax rate you pay on income that exceeds the AGI threshold. Because you lose $3 in itemized deductions for every extra $100 in income, you effectively pay tax on $103, not $100. If you multiply that $3 by your tax rate, you’ll see what you actually lose. If you’re in the 35% bracket, the Pease rule adds 1.05 percentage points to your effective tax rate, while it adds slightly less than 1.2 percentage points to the tax rate of those in the 39.6% bracket.
The trick is to keep your AGI to a manageable level in 2013, perhaps by postponing capital gains and year-end bonuses until 2014. Such moves also might be beneficial to other aspects of your tax return. Please let us know if you have questions about how the Pease limit might affect your tax situation.

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