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Higher Income Taxpayers Hit with Exemption & Itemized Deductions Phase-out

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On December 22, 2017, The Tax Cuts and Jobs Act was signed into law. The information in this article predates the tax reform legislation and may not apply to tax returns starting in the 2018 tax year. You may wish to speak to your tax advisor about the latest tax law. This publication is provided for your convenience and does not constitute legal advice. This publication is protected by copyright.

Higher Income Taxpayers Hit with Exemption & Itemized Deductions Phase-out
Generally, in 2016 and 2017 taxpayers are allowed to deduct personal exemptions of $4,050 for themselves, their spouses and their dependents. In addition, taxpayers are allowed a standard deduction or, if their deductions are large, they can itemize their deductions. .

However, the personal exemptions and itemized deductions for higher income taxpayers are phased out beginning when a taxpayer’s adjusted gross income (AGI) reaches a phase-out threshold amount. 

The threshold amounts are based on the taxpayers’ filing statuses and for 2017 are: $261,500 (up from $259,400 for 2016) for single filers, $287,650 (up from $285,350 for 2016) for individuals filing as heads of households, $313,800 (up from $311,300 for 2016) for married couples filing jointly and $156,900 (up from $155,650 for 2016) for married individuals filing separately. Here is how the phase-out works: 
  • Personal Exemption - The otherwise allowable exemption amounts are reduced by 2% for each $2,500 or part of $2,500 ($1,250 for a married taxpayer filing separately) that the taxpayer’s AGI exceeds the threshold amount for the taxpayer’s filing status.

    Example: Ralph and Louise have an AGI of $426,300 for 2017 and two children for a total of four exemptions totaling $16,200 (4 × $4,050). The threshold for a married couple is $313,800; thus, their income exceeds the threshold by $112,500. Dividing $112,500 by $2,500 equals 45. So 90% (45 × 2%) of their $16,200 exemption allowance is phased out, leaving them with a reduced exemption deduction of $1,620 ((100%–90%) × $16,200). Assuming Ralph and Louise are in the 33% federal tax bracket, the phase-out costs them an additional $4,811 ($16,200 × 90% × 33%) of tax. 

    A divorced or separated parent subject to the phase-out should consider relinquishing the exemption of a dependent child to the other parent. Where a taxpayer is a party to a multiple support agreement, the taxpayer may want to allow another contributing member of the agreement who is not hit by the phase-out to claim the dependent’s exemption.

  • Itemized Deductions - The total amount of itemized deductions is reduced by 3% of the amount by which the taxpayer’s AGI exceeds the threshold amount, with the reduction not to exceed 80% of the otherwise allowable itemized deductions.

    Not all itemized deductions are subject to phase-out. The following deductions are not subject to the phase-out:

    o Medical and dental expenses
    o Investment interest expenses
    o Casualty and theft losses from personal-use property
    o Casualty and theft losses from income-producing property
    o Gambling losses

    Thus, a taxpayer who is subject to the full phase-out still gets to deduct 20% of the deductions subject to the phase-out and 100% of the deductions listed above.

    Example: Ralph and Louise from the previous example, who had an AGI of $426,300 for 2017, exceed the threshold for a married couple by $112,500. Thus, they must reduce their itemized deductions subject to the phase-out by $3,375 (3% of $112,500), but the reduction must not exceed 80% of the deductions subject to the phase-out. For 2017, Ralph and Louise had the following itemized deductions: 


        Subject to Phase-out Not Subject to Phase-out
    Home mortgage interest
    $10,000
    Taxes
    $8,000
    Charitable contributions
    $6,000
    Casualty Loss   
    $12,000
    Total
    $24,000
    $12,000


    The phase-out is the lesser of $3,375 or $19,200 (80% of $24,000). Thus Ralph and Louise’s itemized deductions for 2017 will be $32,625 ($24,000 - $3,375 + $12,000). Assuming Ralph and Louise are in the 33% federal tax bracket, the phase-out will cost them an additional $1,114 ($3,375 × 33%) of tax. 

    Conventional thinking is to maximize deductions. However, where taxpayers normally are not subject to a phase-out and have a high-income year because of unusual income, it may be appropriate, where possible, to defer paying deductible expenses to the year following the high-income year or perhaps pay and deduct the expenses in the preceding year if the out-of-the-ordinary additional income is planned for in advance.
If you have questions about how these phase-outs will impact your specific situation, you want to adjust your withholding or estimated taxes, or you want to make a tax planning appointment, please give this office a call.
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