Many readers of this blog contact me directly with questions and comments. While often the responses are very specific to a particular circumstance, occasionally the subject matter is general enough that it might be of interest to others as well. Accordingly, I will occasionally post a new "MailBag" article, presenting the question or comment (on a strictly anonymous basis!) and my response, in the hopes that the discussion may be useful food for thought.

In this week's MailBag, we look at a question about the interplay between the phaseout of itemized deductions for high income individuals (the so-called "Pease limitation") and potential exposure to the AMT.

Pease Limitation And AMT Exposure

Question/Comment: What is the interplay between the itemized deduction phaseouts and the AMT; e.g., if property taxes are reduced because of the phase out, then I assume the AMT addback is lower. Does that mean that while a client is in the itemized deduction phase-out “phase”, that it “delays” the onset of the AMT because the addbacks are lower? 

You are correct that the phaseout of itemized deductions (also known as the "Pease limitation" that was reinstated under the fiscal cliff legislation) is added back for Alternative Minimum Tax (AMT) purposes (and then separately there are adjustment for whatever deductions the client simply loses outright for the AMT), and this does impact the client's potential exposure to the AMT. However, the relationship is a bit more complex; an example may help to illustrate.

Assume the client is a very high income couple that had $1,000,000 of gross income, and deductions included $70,000 of state income taxes, $15,000 of real estate taxes, and $40,000 of mortgage interest. Total itemized deductions would be $125,000, but due to the high income phaseout the client would lose $21,000 of those deductions (3% of the excess above $300,000 of AGI). While $104,000 would be the net itemized deductions, the AMT would unwind the $21,000 phaseout – bringing the total back to $125,000 – and then begin eliminating AMT adjustments (which would remove the state income taxes and real estate taxes). So the net result for AMT purposes would be $40,000 of deductions (the deductible mortgage interest). You’d then subtract personal/AMT exemptions from each side (although at $1,000,000 of income, both would be fully phased out), apply the appropriate tax rates, and pay the tax liability based on whichever system resulted in the higher amount.

Notably, in this scenario the client’s AMT liability would only be about $265,210, while the regular tax liability would be $302,462, so this client actually would not be close to any AMT exposure anyway. In point of fact, this will be fairly common going forward for higher income clients; the top tax rate of 39.6% is so much higher than the top AMT tax rate of 28% (in fact, it's not always "bad" news to be subject to the AMT because the top rate is "only" 28%!), that in practice it’s difficult for very high income clients to face the AMT. In practice, it’s far more common for AMT exposure to occur in the $150,000 to $450,000 range or so (albeit with greater exposure in states with higher state tax rates). In point of fact, the reality that the AMT strikes a wide swath of "upper middle income" households (but not actually very many ultra-high-income households) is why it's so expensive to repeal.

It's true that the phaseout of the itemized deductions is extending the gap between the couple's regular and AMT tax liabilities a bit further, but it's important to recognize that the phaseout of itemized deductions is actually a function of the client’s income, not the client’s deductions. As a result, it’s actually a bit of a misnomer to call it a phaseout of 3% of itemized deductions; in practice, it functions more like a 3% addition to taxable income (which in turn boosts the marginal tax rate by a fraction of that amount). For instance, noting the earlier example, if the client decided to contribute $50,000 to a charity at $1,000,000 of income, the client would still get the full benefit of the $50,000 deduction, as though the phaseout didn’t exist, because the flat “$21,000 of extra taxable income due to $1,000,000 AGI” was already baked into the equation. Similarly, the benefit of the charitable deduction would apply similarly for both regular and AMT purposes (albeit at different marginal tax rates due to the different brackets), regardless of the presence of the “phaseout” of itemized deductions.

The bottom line is that in practice, the phaseout of itemized deductions functions more like an increase in the ordinary marginal tax rate of about 1% to 1.2% (so the 33% bracket is actually 34%, the 35% is 36.1%, and the 39.6% is about 40.8%). So ultimately, the higher marginal tax rate effect for those above $300,000 of AGI (for couples; $250,000 for individuals) does result in a higher regular tax liability and therefore “delays” the onset of the AMT, but it’s primarily due to the simple fact as regular tax rates rise under the ordinary system, there’s less exposure to the AMT.

Michael E. Kitces

I write about financial planning strategies and practice management ideas, and have created several businesses to help people implement them.

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Out and About

Wednesday, October 7th, 2015

*CPWA Training on Retirement Planning @ IMCA

Wednesday, October 7th, 2015

*Cutting Edge Tax Planning Developments & Opportunities *Social Security Benefits Planning for Couples *Life & Death Tax Planning for Annuities @ Dupage County Estate Planning Council

Tuesday, October 13th, 2015

*Understanding Longevity Annuities and their Potential Role in Retirement *Generating Tax Alpha with Effective Asset Location @ FPA Southern Wisconsin