There are three ways the government can increase the revenue it receives from income taxes: it can increase the tax rates, eliminate tax deductions or credits, or phase-out tax deductions or credits for some taxpayers. By far the way least likely to draw ire from the general public is reducing or phasing out deductions and credits for higher income taxpayers. These reductions don't affect most taxpayers and are hard to understand by those they do affect.
One such deduction reduction that is called the "Pease provision" (named after the Congressman who sponsored it). This provision reduces a high-income taxpayer's itemized deductions. The Pease provision had expired in 2009, but was brought back from the dead by the fiscal cliff tax deal for 2013 and later.
What Are Itemized Deductions?
Itemized deductions are deductions for various personal expenses taxpayers are allowed to take instead of taking the standard deduction. They include deductions for home mortgage interest, charitable contributions, state income taxes, property taxes, medical expenses, investment expenses, and unreimbursed employee expenses. Most people don't itemize their deductions because their deductions don't exceed the annual standard deductions. However, for high income taxpayers, itemized deductions can far exceed the standard deduction.
How Does Pease Work?
The Pease provision reduces a taxpayer's itemized deductions by 3% of the amount his or her adjusted gross income (AGI) exceeds a threshold amount. Under the new law, the Pease thresholds are $300,000 for married taxpayers filing jointly, and $250,000 for single taxpayers.
Thus, for example, a married couple with an AGI of $400,000 and $50,000 in itemized deductions, would be $100,000 over the threshold. 3% of $100,000 = $3,000; so their itemized deductions would be reduced from $50,000 to $47,000. The couple ends up with $3,000 more in taxable income, which at their income level is taxed at a 33% rate. They end up paying $999 in extra taxes.
However, no matter how high a taxpayer's AGI, the Pease reduction cannot exceed 80% of the amount of itemized deductions otherwise allowable for the year. But this still means that a very high-income homeowner could lose up to 80% of his or her itemized deductions for home mortgage interest, state and local income and property taxes, charitable contributions, and other itemized deductions.
Just how much the Pease provision can end up costing varies from taxpayer to taxpayer, and can be hard to quantify. However, those subject to the Pease provision can expect to pay about 1% more in income taxes in 2013 and later.