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Watch Out for the Itemized Deductions Trap

Remember when you could claim itemized deductions on your tax return with no restraints? Those good old days are long gone. Under the Pease rule—named for the Ohio congressman who initially introduced the concept a quarter of a century ago—upper-income taxpayers may lose some bang from their bucks.

How it works: Certain itemized deductions are reduced if your adjusted gross income (AGI) exceeds an annual dollar threshold. This provision was initially included in the Omnibus Budget Reconciliation Act of 1990 before it was gradually phased out in the early 2000s. But the Pease rule was fully reinstated in 2013 and applies currently and for the foreseeable future.

Note that the Pease rule does not apply to all itemized deductions, although several “big-ticket items” are on the list. These include charitable donations, mortgage interest, state and local income taxes, property taxes and miscellaneous expenses. Conversely, the Pease rule does not cover medical expense deductions, investment interest deductions, casualty and theft deductions, or gambling loss deductions, but these deductions already have built-in lim- its. For instance, medical expense deductions are generally limited to the excess above 10% of your AGI on your 2015 tax return (7.5% of AGI if you are age 65 or older).

For 2015 returns, the reduction is equal to 3% of the excess above $258,250 for single filers and $309,900 for joint filers. (These amounts are indexed for inflation.) However, in no case can the reduction be greater than 80% of your total deductions. This limit affects only the wealthiest of taxpayers.

Example  1:  Archie  exceeds  the  AGI  threshold by $200,000 and has $50,000 in annual deductions from charitable gifts, mortgage interest, and state and local taxes. As a result, the reduction is equal to 3% of the $200,000 excess, or $6,000. Thus, his itemized deductions of $50,000 are scaled back to $44,000.

Example 2: Betty exceeds the AGI threshold by $1 mil- lion and has $35,000 in annual deductions from chari- table gifts, mortgage interest, and state and local taxes. Normally, the reduction under the Pease rule would be equal to 3% of the $1 million excess, or $30,000, cutting back her affected deductions to only $5,000. But this would be a reduction  greater  than  80%.  As a result, the reduction cannot be more than $28,000, so Betty may deduct $7,000.

The Pease rule does not figure in the alternative minimum tax (AMT) calculation for individual taxpayers. But certain itemized deductions— including mortgage interest and state and local income taxes—are already disallowed under the AMT.

Another comparable tax law provision phases out the tax benefit of personal exemptions for high-income tax- payers at the same indexed thresholds as the phaseout of itemized deductions. Obtain more details from your tax advisers.

If you would like to have a conversation about this topic or other tax savings ideas, please contact Jim Forbes at 440-605-7156or jforbes@skodaminotti.com.

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