After we released our alert on the American Taxpayer Relief Act of 2012, we received a few inquiries about how the phase-out of itemized deductions will work. The phase-out of itemized deductions returns to the tax code in 2013 after a several-year absence and the American Taxpayer Relief Act of 2012 increased the threshold amounts in cases in which it becomes applicable.
Assume that a married couple filing a joint return has an adjusted gross income of $1 million and itemized deductions for state income taxes and charitable contributions of $200,000. The deduction amount disallowed under the phase-out is an amount equal to 3 percent of the excess of the taxpayer’s adjusted gross income over $300,000 for taxpayers filing a joint return ($250,000 for single taxpayers or $150,000 for a married taxpayer filing a separate return). These threshold numbers will be adjusted for inflation after 2013. The excess amount in this example is $700,000 ($1 million adjusted gross income minus $300,000) and 3 percent of that amount is $21,000, so the taxpayers would lose $21,000 of their $200,000 of itemized deductions.
The phase-out applies to all itemized deductions except for medical expenses, investment interest, casualty and theft losses, and permitted wagering losses. The disallowance under this provision, however, is limited to 80 percent of a taxpayer’s total itemized deductions. All taxpayers, regardless of the level of their adjusted gross income, are permitted to keep at least 20 percent of their itemized deductions. For taxpayers who pay income tax at the maximum rate of 39.6 percent, the phase-out adds about 1.2 percentage points to their effective marginal tax rate.