Limitations for High-Income Taxpayers

Among the tax increases recently enacted in the 2012 American Taxpayer Relief Act are provisions that impose caps on tax breaks for high income taxpayers.

The new rules reinstate the personal exemption phase-out (PEP) and the limitation on itemized deductions known as the “Pease Limitation,” named for former U. S. Representative Donald Pease (D-Ohio), who introduced the legislation that created the limitation. The Pease limitation had been temporarily repealed through 2012 but returns for the tax year 2013.

PEP

Taxpayers claim personal exemption deductions for themselves, their spouses and their dependents. The personal exemption amount per person was $3,800 in 2012 and is $3,900 in 2013.

Beginning in 2013, the value of each personal exemption is reduced by 2% for each $2,500 (or portion thereof) by which the taxpayer’s adjusted gross income (AGI) exceeds the applicable threshold.

The starting thresholds are:

• $300,000 for married couples filing jointly and surviving spouses

• $275,000 for heads of household

• $250,000 for unmarried taxpayers

• $150,000 for married taxpayers filing separately

Example:

Consider a married couple filing a joint return with no other dependents and an adjusted gross income of $400,000. The PEP “applicable percentage” applies to $100,000 (that is $400,000 AGI — $300,000 threshold).

For each $2,500 of that $100,000 amount, a 2% reduction in the exemption amount of $3,900 applies. So the percentage reduction is 80% [2% x ($100,000 / $2500)], resulting in an exemption amount of $780 [$3,900 — (80% x $3,900)] per person. Therefore, only $1,560 ($780 x 2) will be allowed as the personal exemption deduction on the joint return.

Itemized deductions

Also beginning in 2013, the “Pease Limitation” of itemized deductions is reinstated. The phase-out limitation reduces the amount of deductions you can take by 3% of your AGI above the specified thresholds but not to exceed 80% of the affected deductions.

This means that taxpayers whose AGI is greater than the specified thresholds won’t be able to deduct all of their home mortgage interest, charitable contributions, and state and local income tax payments. Medical expenses, investment interest, casualty and theft losses, and gambling losses are not subject to the Pease Limitation, although those deductions could be subject to other limitations.

The thresholds for this limitation are the same as for PEP:

• $300,000 for married couples filing jointly and surviving spouses

• $275,000 for heads of household

• $250,000 for unmarried taxpayers

• $150,000 for married taxpayers filing separately

Example:

Consider a married couple filing a joint return with adjusted gross income of $400,000 who has $50,000 of itemized deductions, consisting of $20,000 of mortgage interest, $10,000 of real estate taxes and $20,000 of charitable contributions.

The couple’s total itemized deductions of $50,000 are reduced by $3,000 [3% x (400,000 — 300,000)]. The $3,000 reduction is the lesser of (a) 3% of the excess of AGI over the applicable threshold amount or (b) 80% of the itemized deductions otherwise allowable for the tax year.

Gene Barker, CPA, is a tax manager with Warren Averett, LLC. Gene Barker joined the firm in 1979 and is a member in the firm’s Tax Division and Healthcare Practice Group. Gene has 34 years of experience in accounting, tax and consulting services. Gene can be reached at Gene.Barker@warrenaverett.com.Warren Averett, LLC, is also a proud member of the National CPA Health Care Advisors Association. HCAA is a nationwide network of CPA firms devoted to serving the health care industry. Members provide proactive solutions to the accounting needs of physicians and physician groups. For more information contact the HCAA at info@hcaa.com.