By Kaye A. Thomas
Current as of January 11, 2013
A rule that reduces itemized deductions for relatively high-income taxpayers is sometimes called the Pease rule, for the congressman who originated the idea. It’s often mentioned together with the personal exemption phaseout, which goes by its initials — hence the duo of PEP and Pease. This page explains the Pease rule.
See also: Personal Exemption Phaseout
Pease was eliminated as part of the tax cuts enacted under George W. Bush but sprang back to life when those tax cuts expired at the end of 2012. The American Taxpayer Relief Act of 2013 raised the income levels at which the Pease rule starts to apply.
The Pease rule is often misunderstood. As explained below, normally it simply increases the rate of tax on income above the threshold level by about 1 percentage point, rather than affecting the benefit you receive from any particular itemized deduction.
The Pease rule begins to apply at the same income levels as the personal exemption phaseout. It affects your tax when adjusted gross income exceeds a dollar amount that depends on your filing status:
- Married filing jointly: $300,000
- Head of household: $275,000
- Single: $250,000
- Married filing separately: $150,000
These amounts will be adjusted for inflation after 2013. Note that these are dollar amounts of adjusted gross income (“AGI”), not taxable income. Capital gains are included in AGI, so the Pease rule can be triggered by a capital gain.
Certain itemized deductions protected
We’ll see later that few taxpayers have to be concerned with the application of the Pease rule to particular itemized deductions. For those few taxpayers, the following itemized deductions are protected from application of the Pease rule:
- Medical expenses
- Investment interest expense
- Casualty or theft losses
In the discussion that follows we’ll refer to all others (including home mortgage interest, state and local taxes, and charitable contributions) as unprotected itemized deductions.
Unprotected itemized deductions are reduced by the lesser of two amounts:
- 3% of the amount by which AGI exceeds the threshold amounts listed above
- 80% of unprotected itemized deductions
In other words, you always get to claim at least 20% of your unprotected itemized deductions (in addition to 100% of your protected itemized deductions), even if the 3% rule would otherwise reduce them below that level.
Example: Your AGI is $1,000,000 above the Pease threshold and your unprotected itemized deductions add up to $32,000. The 3% rule would reduce these deductions by $30,000, leaving you with only $2,000. Because of the 80% rule, you can deduct $6,400 (20% of $32,000).
If you had $40,000 in unprotected itemized deductions (instead of the $32,000 in this example), the 80% rule would not apply. Your deductions would be reduced by $30,000, so you would be allowed to deduct $10,000, which is more than 20% of the total.
Effect on planning for itemized deductions
The vast majority of individuals with income high enough to be affected by the Pease rule also have unprotected itemized deductions large enough so that the 80% rule is irrelevant, and the only rule that matters is the 3% rule. If you live in one of the 41 states that have a broad-based income tax, this cost alone will almost surely boost your itemized deductions to that level. In other states, property tax, sales tax, mortgage interest and charitable contributions are likely to do the trick.
IRS statistics indicate that for individuals with income about $1,000,000 above the Pease threshold (where the reduction in itemized deductions would be about $30,000) the average total of itemized deductions is over $100,000.
If, like most people, you’re securely within the category of taxpayer for whom the 80% rule doesn’t matter, then the Pease rule does not have any effect on tax planning for itemized deductions. You will still get the full benefit of any increase in those deductions.
Example: Your AGI is $1,000,000 above the Pease threshold and your only itemized deduction is $70,000 in state income tax. You’re considering making a $10,000 charitable contribution.
The Pease rule reduces your itemized deductions by $30,000, so you’ll get to deduct $40,000 if you don’t make the charitable contribution. If you do make this contribution, your deductions increase to $80,000 while the reduction in the deductions remains at $30,000, so you get to deduct $50,000. The amount you can deduct goes up by $10,000, the full amount of your contribution.
Some commentators have suggested that the Pease rule will affect charitable giving and other forms of itemized deduction planning, but the number of people for whom this might be true is very small.
The true practical effect of the Pease rule is to increase the rate of tax you pay on income above the threshold, generally by a little over 1 percentage point. Every time you earn another $100, you lose $3 in itemized deductions, so your taxable income goes up by $103. Instead of paying tax on $100 of additional income, you pay tax on $103 of additional income.
Multiply that $3 differential by your tax rate to get the actual tax effect. If you’re in the 35% bracket, the Pease rule adds 1.05 percentage points to your effective tax rate. In the 39.6% bracket it adds a little less than 1.2 percentage points.
For the vast majority of those affected by the Pease rule, this is the only real effect: it increases the rate of tax on income above the threshold amount by a little more than 1 percentage point. As a practical matter you can ignore the fact that the rule is tied to itemized deductions. It has the same effect (except on a small percentage of taxpayers) as a rule saying every $100 of income you earn above the threshold counts as $103.