By Cathy Peters
The rule that reduces itemized deductions for relatively high-income taxpayers is known as the “Pease Limitation” named after Congressman Donald Pease who authored the original legislation. The personal exemption phase-out (PEP) reduces or eliminates the deduction for personal exemptions. These phase-outs were reinstated as part of the American Taxpayer Relief Act of 2012 in an effort to avoid the fiscal cliff. Both of these phase-outs apply at the same income levels. They affect your tax when adjusted gross income (not taxable income) exceeds an income threshold amount depending on your filing status. The 2014 income threshold amounts by filing status are:
Single – $254,200
Married Filing Joint – $305,050
Head of Household – $279,650
The Pease Limitation
Certain itemized deductions are protected from the Pease limitation and will not be reduced. They include the following:
- Medical Expenses
- Investment Interest Expense
- Casualty and Theft Losses
All other itemized deductions are unprotected and subject to the Pease limitation and include the following:
- Mortgage Interest
- State and Local Taxes
- Contributions
- Miscellaneous Itemized Deduction
Under the Pease rule, the unprotected itemized deductions are reduced by the lesser of:
- 3% of the amount that adjusted gross income exceeds the income threshold for your filing status
- 80% of your unprotected itemized deductions listed above
As a practical matter, most taxpayers who have income high enough to be effected by the Pease limitation will have itemized deductions large enough that the 80% rule is irrelevant and the 3% rule is applied which is tied to income rather than itemized deductions. Increases or decreases in itemized deductions will not change the amount of the reduction when the limitation is based on the 3% rule. Therefore it simply increases the rate of tax you pay on income above the threshold amount by a little over 1%, rather than affecting the benefit you receive from any particular itemized deductions.
Personal Exemption Phaseout
The personal exemption phase-out begins to apply at the same income levels as the Pease limitation. For each $2,500, or fraction thereof, by which you adjusted gross income exceed the threshold amount for your filing status, your personal exemption deduction is reduced by 2 percentage points until completed eliminated when income reaches the following levels:
Single Filers – $376,700
Married Filing Joint – $427,550
Head of Household – $402,150
The effect is to increase your marginal tax rate by approximately 1% for each personal exemption that is lost.
Both of these phaseouts are complex and confusing. If your income is above these levels, there are planning opportunities available that could minimize the effect of these limitations.