THE ITEMIZED DEDUCTION PHASEOUT AND OBAMA’S PROPOSED 28% CAP. Or—How Did One Tax Provision Get So Out of Control?

One of the cornerstone goals in President Obama’s recently released fiscal year 2010 budget is to increase health insurance coverage for millions of uninsured Americans. To generate funds for this initiative, the Administration has proposed capping the benefit of itemized deductions at 28% for taxpayers with adjusted gross income (AGI) over $250,000. This one proposal, in a 142-page budget document, could be the most controversial, because of the potential effect on charitable giving. But the bigger story for tax practitioners is in the details of the itemized deduction limits.

Section 68 of the Internal Revenue Code, first added in 1990 during the George H.W. Bush Administration (Remember “Read my lips. No new taxes.”?), established an overall limitation on itemized deductions. This provision was made permanent during President Clinton’s tenure, but its effect was limited by the second President Bush. Although it is scheduled to go away—or sunset—as of 2010, President Obama has proposed keeping it in place and adding another layer of complexity. If successful, these further changes will result in one of the most complicated single concepts to creep into the Code through the back door. (This limit is called the “Pease” limitation for its original Congressional author.)

Rather than abolish certain deductions or limit them outright, Congress has chipped away at itemized deductions by establishing at once, both ceilings and floors and walls and basements! Well, maybe that is a bit of an exaggeration, but let’s examine the details so you can judge for yourself.

Original Provision To calculate the original limitation, you would apply all regular limits to individual itemized deductions. Then, that total would be reduced by the lesser of (a) 3% of the amount by which AGI exceeded $100,000 ($50,000 for married filing separately), or (b) 80% of the otherwise allowed itemized deductions. Thus, a taxpayer would get at least 20% of the total itemized deductions. When the law was first passed, the AGI limit was $100,000. With inflation indexing, it is now $166,800 ($83,400 for married filing separately).

Example: Assume the original AGI threshold limit of $100,000 and married taxpayers with an AGI of $200,000 have the following itemized deductions: $10,000 mortgage interest $15,000 charitable contributions $5,000 state income taxes $30,000 Total itemized deductions

Possible reduction: The lesser of

(a) 3% of $100,000 (the amount by which their AGI exceeds $100,000) = $3,000

(b) 80% of itemized deductions = $24,000.

In this case, (a) above would be the lesser figure–$3,000. Thus, the taxpayers’ itemized deductions for the year would be reduced by $3,000, from $30,000 to $27,000. The final result would be that these taxpayers would have $3,000 more in income taxed at their highest marginal rate.

Note that the limitation does not apply to certain deductions, including the medical expense deduction, investment interest deduction, casualty and theft loss deductions, and gambling loss deductions.

Bush II Softened the Blow In 2001, the George W. Bush Administration successfully backed off the limitation through legislation phasing out the phase-out. The Senate report on the bill gave this reason: “The Committee believes that the overall limitation on itemized deductions is an unnecessarily complex way to impose taxes and that the “hidden” way in which the limitation raises marginal rates undermines respect for the tax laws.”

Here’s how this second tier works: –For taxable years 2006 and 2007, the reduction amount is reduced by 1/3. –For 2008 and 2009, the reduction amount is reduced by 2/3. –For 2010, the reduction amount is abolished.

So, in our example above, in 2006 and 2007, the reduction would itself be reduced by 1/3 as follows:

Possible 2006-2007 reduction: The lesser of

(a) 2/3 of 3% of $100,000 (the amount by which their AGI exceeds $100,000 = $2,000

(b) 2/3 of 80% of itemized deductions = $16,000

Note: The actual AGI threshold for these years was higher, but we used the original $100,000 threshold for comparison purposes. Possible 2008-2009 reduction: The lesser of (a) 1/3 of 3% of $100,000 (the amount by which their AGI exceeds $100,000 = $1,000 (b) 1/3 of 80% of itemized deductions = $8,000 Note: The 2008 AGI threshold is $159,950 for married couples. We used the $100,000 threshold for comparison purposes. (See attached 1040 worksheet below)

Tax Year 2010: Section 68 would be gone, and all itemized deductions would be allowed as before 1990. Sounds good. Right? Don’t breathe your sign of relief yet. The problem with the Bush II tax legislation is that it all goes away entirely in 2011. Hence, the itemized deduction limit reverts to pre-2001 status, with the original full 3% / 80% phase-outs back in place.

Current Proposal

The Obama budget proposal would reinstate the original 3% / 80% Section 68 limit in 2011. On top of this limit, Obama would limit the resulting itemized deduction benefit to a marginal tax rate of 28% for married taxpayers with AGI over $250,000 and single taxpayers with AGI over $200,000. The effect of this cap is that itemized deductions will not create the same amount of tax savings as they previously did.

For example, a taxpayer who is in the 35% percent tax bracket would normally see a $35.00 benefit for every $100 in itemized deductions. Under the Administration’s proposed cap, that same taxpayer would only see a tax benefit of $28.00 for every $100 in itemized deductions. Coupled with the proposed increase in marginal rates, which under the Bush II plan are now scheduled to go back to their pre-2001 levels, the reduction in value can be up to 11.6%–the spread between the top marginal rate of 39.6% and the 28% deduction cap.

Arguments For and Against

The nonprofit sector is leading the opposition to the plan. Charities argue that the proposal will reduce charitable giving by the wealthy possibly by several billion dollars per year, according to one study. On the other hand, supporters of the cap believe that the added benefit from having better health care coverage in the United States will reduce the demand for charitable services.

The real estate industry has joined the fight, stating that limiting the mortgage interest deduction will further depress home prices and stall any recovery in that market. Homebuilders and those in their supply chain will be greatly impacted in those areas of the country with high housing costs, such as the northeast, California, and Florida.

Prospects for Change

Congress has heard these complaints and both Republicans and powerful Democrats have expressed concern over the Obama proposals. Senate Finance Committee Chairman Max Baucus (D-Mont.) and House Ways and Means Committee Chairman Charles B. Rangel (D-NY) appear to have lined up in opposition. Without these two tax leaders, the proposal is most likely dead on arrival. However, given the overall support in the Democratically controlled Congress for reinstating higher taxes on the wealthy, the proposal may pass. Most tax watchers agree, nevertheless, that even if the 28% deduction limit goes through, there likely will be an exemption for charitable contribution deductions.

Budget Status

As the Federal Tax Alert went to press, the House and Senate had reached a compromise on the 2010 Budget resolution, H. Con. Res. 13, setting the broad revenue and spending limits for the coming fiscal year. Although the budget resolution does not have the full force of law, it provides the benchmarks where Congress will begin when filling in the details of its tax and spending provisions in this year’s omnibus tax and appropriations bills. In this resolution, Congress sidestepped the itemized deduction cap vote for now, issuing the following statement in its Joint Explanatory Statement on the resolution with regard to which specific revenue raisers will be used to meet budget goals:

The President’s budget proposes a variety of other revenue offsets. Unless expressly provided, this resolution does not assume any of the specific revenue offset proposals provided for in the President’s budget. Decisions about specific revenue offsets are made by the House Committee on Ways and Means and the Senate Committee on Finance, which are the taxwriting committees.

Observation: A similar coalition to those now fighting the 28% cap for charitable contributions kept the charitable contribution deduction out of the list of minimum tax preferences in the 1986 reenactment of the Internal Revenue Code. At that time, Senator Patrick Moynihan of New York led the fight. Now Rep. Charles Rangel of New York has stepped into his shoes.

Information provided by the National Society of Tax Professionals