Legislation enacted on January 1, 2013, (known officially as the American Taxpayer Relief Act of 2012) revived partial disallowances of write-offs for dependency exemptions and most itemized deductions. The provision affects higher-income individuals, starting with returns for calendar year 2013.
The complex limitations went on the books in 1991 during the senior Bush presidency. The phase-outs of exemptions and deductions were immediately labeled "stealth" or "backdoor" tax hikes because their effect is to exact more taxes without raising rates. They remained in effect for almost two decades, until their elimination in 2010, a decision that had the support of no less than the top officials of the IRS, whose National Taxpayer Advocate said that "the confusing and complex calculations for determining allowable deductions add a significant tax and economic burden to a growing number of taxpayers."
The revived curtailments for exemptions and deductions apply just to individuals deemed affluent, meaning their adjusted gross income exceeds designated amounts. For 2014, the numbers are $254,200 for singles, $305,050 for joint filers, $279,650 for heads of households and $152,525 for married persons filing separately. The AGI thresholds will increase in later years, as they're indexed, meaning adjusted annually to reflect inflation, same as the tax brackets, dependency exemptions, and standard deduction amounts.
The legislation places a cap on phase-outs. It's 3 percent of the amount by which a person's AGI exceeds the applicable threshold. And it can't reduce otherwise allowable deductions by more than 80 percent, no matter how high a person's AGI.
To illustrate how the rules work for 2014, assume a married couple's AGI puts them $100,000 above their threshold of $305,050, and their itemized deductions aggregate $50,000. They aren't subject to the alternative minimum tax, which completely disallows deductions for state and local taxes and most miscellaneous expenses. So their deductions might drop by as much as $3,000—from $50,000 to $47,000.
The restrictions apply to several categories of deductions, including: state and local taxes—particularly irksome for filers in high-income-tax states like California, Connecticut, Massachusetts, New Jersey, and New York; interest on home mortgages; real estate taxes; charitable contributions; and miscellaneous expenses, such as job-hunting expenses and investors' expenses already limited, in most cases, to the amount above 2 percent of AGI.
There are reprieves for four kinds of write-offs. But the exceptions are for deductions already subject to limitations. The disallowance doesn't apply to the following write-offs:
- Medical expenses—deductible only for amounts above 10 percent of AGI (7.5 percent for individuals 65 or older through the end of 2016).
- Casualty and theft losses—allowable only to the extent such uninsured losses exceed $100 for each casualty or theft, plus 10 percent of AGI.
- Gambling losses—allowable just to the extent of gambling winnings.
- Interest on funds borrowed to finance investments, such as margin accounts used to buy stocks. Investment interest expenses are allowable just to the extent of investment income, a category that includes interest and, subject to restrictions, dividends and capital gains taxed at ordinary rates.
The disallowance rules establish thresholds that require a person to pay more income taxes solely because he or she is married. Congress allows two cohabitating singles to each have an AGI of as much as $254,200 without exceeding the threshold. Congress penalizes them if they marry. An AGI above $305,050 causes them to forfeit deductions.
The curtailment causes exemptions to gradually disappear when AGI surpasses certain levels. The disallowance affects all exemptions that can be claimed on a return, including those for yourself and your spouse.
For 2014, exemptions must be reduced when AGI exceeds: $254,200 for singles; $279,650 for heads of households; $305,050 for joint filers; and $152,525 for married persons filing separately. Targeted taxpayers must reduce the amount of their exemptions by 2 percent for every $2,500 ($1,250 for married persons filing separately) by which their AGI exceeds the applicable thresholds. Exemptions vanish when AGI is greater than: $376,700; $402,150; $427,550; and $213,775 for singles, heads of households, joint filers and married persons filing separately, respectively.
About the author:
Julian Block writes and practices law in Larchmont, New York, and was formerly with the IRS as a special agent (criminal investigator) and an attorney. More on this topic is available from "Julian Block's Year Round Tax Strategies", available at julianblocktaxexpert.com.