The American Taxpayer Relief Act of 2012, also known as the fiscal cliff tax deal, added limitations to deductions that the wealthy can take. The limits to the deductions are the result of what is known as the Pease Limitation, which was first put into practice in 1990.
While Limitations were subsequently removed, they are back now for 2013 – and for the future. As a result, the wealthy, when itemizing their taxes, are limited to the amount they can take.
For the purposes of the Pease Limitations in 2013, “wealthy” is considered to be $300,000 AGI for joint filers, and $250,000 AGI for single filers. In future years, the threshold will be adjusted for inflation.
Which Deductions are Limited for the Wealthy?
The limited deductions include those that many upper middle class families most benefit from. They are:
- Charitable contributions
- Mortgage interest
- State and local taxes
- Property taxes
- Miscellaneous deductions
The reason that the wealthy itemize their deductions is to use the amount spent to reduce their income, thereby reducing how much they owe in taxes. The threshold is set at AGI, which means that income is determined based on gross income minus above-the-line deductions.
How Does the Pease Limitation Work?
If your AGI is above the threshold, you can still take the deductions, but you won’t be able to take the full amount that you would have been able to take in years past. The limit placed on the deductions is the lesser of either 3% of the amount above the threshold, or 80% of the itemized amount that would have been taken.
So, if you are single and have an AGI of $400,000, the difference between the AGI and the threshold of $250,000 is $150,000. Now, consider that you normally take $30,000 in combined deductions for charitable contributions, mortgage interest, applicable taxes, and miscellaneous deductions.
Your first task is to figure out what will reduce your deductions the least. 3% of the $150,000 difference is $4,500, and 80% of $30,000 is $24,000. So, in this case, the lesser is $4,500, so your total deductions under the Pease Limitation would be reduced by that amount. So, you subtract $4,500 from $30,000 to arrive at $25,500 as the total deduction you are allowed to take.
It’s important to realize, though, that other itemized deductions, like gambling losses and qualified medical expenses, aren’t subject to the Limitation. However, they have their own limitations, since some of the expenses are subject to their own thresholds. For instance, with some deductions you can only take the amount that is beyond 2% of your AGI. There is a specific formula for figuring the deduction for property losses, and you can only take medical expenses deductions in the amount above 10% of your AGI.
If you are wealthy, your ability to reduce your income through itemized reductions will likely mean a higher tax bill. If you want to limit the damage, you might need to consider ways to reduce your above-the-line deductions, since they help you figure your AGI.
Now is a good time to plan ahead. Since the limitations go into effect for tax year 2013, you can work with your accountant right now on some strategies. However, the reality is that you will probably be paying a little bit more in taxes regardless.