Deduction Reduction Redux – Pease Limitation Back in Action

The American Taxpayer Relief Act signed into law on January 3 resurrects the “Pease” limitation on itemized deductions that was in effect from the late 1990s until it was completely phased out in 2010.

This limitation requires taxpayers with adjusted gross income (AGI) above a specified threshold to reduce their itemized deductions by 3% of the amount by which their AGI exceeds the threshold. The reduction also has its own limit: it cannot reduce total itemized deductions by more than 80%. In addition, it does not apply to deductions for medical expenses, investment interest, casualty and theft losses, and gambling losses. The thresholds are as follows (they will be indexed for inflation after 2013):

Filing Status	AGI Threshold
Married filing jointly/Surviving spouse	$300,000
Head of household	$275,000
Single	$250,000
Married filing separately	$150,000

These thresholds are substantially higher than the ones in force before 2010. For example, CCH estimates that under the old rules the threshold for married filing jointly taxpayers would have been $178,150 for 2013, far lower than the new $300,000. As a result, the limitation will apply to fewer donors than in the past, and when it does apply, it will reduce itemized deductions less than if the old indexed thresholds were back. For instance, the reduction will be about $3,550 less for a married filing jointly couple with an AGI over $300,000 than if a $178,150 threshold applied.

Past experience suggests that the Pease limitation had no more than a mild effect on charitable contributions. Now, that effect should be even milder because of the higher thresholds.

An example will demonstrate that the Pease limitation reduces the amount of charitable deductions only for donors either with very high income or with high income but few or no itemized deductions other than charitable contribution deductions.

Example
Mr. and Mrs. Smith file a joint tax return. Between them, they have a total AGI of $500,000.  They have taken itemized deductions for $20,000 in real estate taxes and $10,000 in mortgage interest, as well as $50,000 in charitable deductions, for a total of $80,000 in itemized deductions. Because of the Pease limitation, their itemized deductions will be reduced to $74,000 as follows:

$500,000 - $300,000 = $200,000	Amount subject to 3% deduction reduction
$200,000 x 3% = $6,000	Amount of deduction reduction
$80,000 - $6,000 = $74,000	Amount of itemized deductions after reduction

    

 

 

Notice that the Smiths’ real estate taxes and mortgage interest deductions far exceed their $6,000 Pease limitation. The $6,000 reduction can be thought of as affecting the value of only these deductions. Consequently, the Smiths’ charitable deductions will reduce their total income tax due by the same amount, with or without the $6,000 reduction. The Smiths would need a combined AGI of over $1.2 million before the reduction in their total itemized deductions started eating into their itemized charitable deductions. If they lived in a state with a state income tax, and most people do, they would itemize a state income tax deduction and need an even greater combined AGI before their charitable deductions were reduced!

The tax benefit of the Smiths’ charitable deductions would most likely be affected if they not only lived in a state without an income tax, but also did not own real estate on which to pay tax, and did not hold a mortgage on which to pay interest.  In this case, they might have few or no itemized deductions subject to the Pease limitation apart from their charitable contributions. As a result, the $6,000 reduction would come right out of their $50,000 in contribution deductions.

When does the 80% limitation come into play? Suppose the Smiths had an impressive combined AGI of $2.5 million. In this case, their tentative reduction would be 3% of ($2,500,000 - $300,000), or $66,000. But 80% of their $80,000 in itemized deductions is only $64,000, which is less than $66,000. Obeying the 80% limit, their deductions would be reduced to $16,000 ($80,000 - $64,000), not $14,000 ($80,000 - $66,000).

Conclusion
The Pease limitation adds a layer of complexity for high income donors, which could discourage some donors from making as many charitable gifts. In most cases, however, even for many donors with an AGI above the applicable threshold, the limitation will not constrain the amount by which their charitable deductions can reduce their income tax. From the viewpoint of tax incentives, the limitation should affect the charitable giving of only a tiny fraction of all donors.