Watch Out For Tax Traps In The Fiscal Cliff Law

There’s a lot to like for most taxpayers in the American Taxpayer Relief Act (ATRA), the eleventh-hour legislation that Congress enacted just as we were about to go over the “fiscal cliff.” The new law generally preserves favorable income tax rates on investment income, although some upper-income investors now must pay higher rates. And ATRA provides much-needed relief from the alternative minimum tax (AMT) and estate taxes, while extending a slew of other tax breaks, though with a few modifications.

But there’s also some bad news tucked away in the 157 pages of the law. In particular, there are two new tax traps that effectively could reduce your tax refund for the 2013 tax year or increase the amount you’ll have to pay Uncle Sam. The two potential stumbling blocks are commonly referred to as the “Pease rule” and the “PEP rule” (for “personal exemption phaseout”).

The Pease Rule. Under the Pease rule (named for the congressman who initially championed this amendment in the 1980s), most itemized deductions are reduced by 3% of the amount that your adjusted gross income (AGI) exceeds a specified dollar threshold, though they can’t be cut by more than 80% overall. This provision in the tax law was phased out gradually by the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA). However, it was scheduled to return in 2011, before the 2010 Tax Relief Act provided a temporary reprieve through 2012. Now, finally, the Pease rule has been revived permanently.

At least ATRA raises the dollar thresholds from the levels that originally were scheduled for 2013. Previously, the limit would have been $178,150 for both single and joint filers, based on an inflation adjustment. Under ATRA, the dollar threshold is $250,000 for single filers and $300,000 for joint filers. Make more than that, though, and you could stand to lose a portion of your itemized deductions due to this rule.

Example: Suppose you’re a joint filer with an AGI of $400,000 in 2013. That’s $100,000 above the threshold, and so the $50,000 in itemized deductions that you claimed will be reduced by the Pease rule to $47,000 – ($50,000 minus 3% of $100,000).

Note that the Pease rule applies to many of the deductions that are likely to produce big write-offs, such as charitable donations, mortgage interest, state and local income taxes, and property taxes and miscellaneous expenses. On the other hand, it doesn’t apply to deductions for medical expenses, investment interest, or casualty and theft or gambling losses, because those already have their own built-in thresholds.

The PEP Rule. The PEP rule has followed a path similar to that of the Pease rule. It was phased out gradually by EGTRRA before reinstatement of this provision was postponed by the 2010 Tax Relief Act. Now the PEP rule is back with a vengeance for 2013 and thereafter.

This onerous rule reduces the total amount of personal exemptions you may claim—including for yourself, your spouse (if you’re married), and your dependents—by 2% for each $2,500 (or portion thereof) by which your AGI exceeds a specified dollar threshold. Each exemption in 2013 is $3,900. Unlike the Pease rule, there’s no limit on the overall amount of the reduction with the PEP rule, so personal exemptions could be phased out completely for some high-income taxpayers.

As with the rule for itemized deductions, however, ATRA raises the applicable thresholds for the PEP rule to $250,000 for single filers and $300,000 for joint filers. Without this change, the thresholds for 2013 would have been $178,150 for single filers and $267,200 for joint filers. Yet the reduction of exemptions still can be significant.

Example: Suppose you’re a joint filer with an AGI of $400,000 in 2013 and you’re entitled to a total of four personal exemptions. Under the PEP rule, your exemptions are reduced by 2% of each $2,500 above the limit for AGI, or a total of 80%—40 ($100,000 divided by $2,500) times 2%. Therefore, your personal exemptions of $15,600 ($3,900 times four) are reduced all the way down to $3,120.

The reinstatement of the Pease and PEP rules could affect tax planning for high-income people. For instance, when appropriate, you might accelerate or postpone certain deductible expenses at the end of the year, depending on your personal circumstances. Make sure you take all of the prevailing rules into account.