The
impact on the charitable deduction of the new phase-out of itemized deductions
Mitchell Silberberg & Knupp LLP
David Wheeler Newman
January 31 2013
Mitchell Silberberg & Knupp LLP logo
As
has been widely reported, a concerted effort by a coalition of charitable
organizations in the middle of the “fiscal cliff” negotiations successfully
preserved the charitable contribution income tax deduction against proposals
from both the Administration and members of Congress to cap or otherwise limit
the charitable deduction. The celebration over this legislative victory was
muted, however, as a result of the return to the Internal Revenue Code of the phase-out
of itemized deductions. Many in the charitable sector view this phase-out as
somehow taking back some of the hard-earned victory to preserve the charitable
deduction. Charitable gift planners are concerned that the phase-out will
reduce tax incentives for charitable gifts and therefore result in reduced
giving. However, for most donors this is simply not the case.
The
phase-out of itemized deductions under the American Taxpayer Relief Act of 2012
will not reduce the value of charitable contribution deductions for most
taxpayers. It is critically important for gift planners to educate donors on
this point, and to demonstrate that charitable contribution deductions will in
most cases be unaffected by the new tax act.
Mechanics
Starting
in 2013, itemized deductions are phased out for taxpayers with adjusted gross
incomes above a threshold, which is $300,000 for married taxpayers filing
jointly, $250,000 for single taxpayers, $275,000 for heads of households, and
$150,000 for married taxpayers filing separately. These thresholds will be
adjusted for inflation. The reduction resulting from this phase-out is the
lesser of (a) 3% of the excess of adjusted gross income over the threshold or
(b) 80% of otherwise allowable itemized deductions.
Example
1
Assume
that a married couple with an adjusted gross income of $1 million resides in a
high-tax state like California or New York. We know that the potential
reduction in their itemized deductions will be $21,000, that is, 3% of
$700,000, the amount by which their AGI ($1 million) exceeds the threshold
($300,000). The couple plans to make a charitable contribution of $100,000.
Their other itemized deductions are state and local taxes, including property
taxes, of $150,000, and home mortgage interest of $50,000. Thus, their total
itemized deductions of $300,000 will be reduced by $21,000 to $279,000. Assume
for a moment that no charitable contribution is made. In this case, the other
deductions of $200,000 will be reduced by the same $21,000, with $179,000 after
the reduction. In other words, the full amount of the charitable contribution
deduction of $100,000 is unaffected by the new phase-out rule.
The
key point of Example 1 is that high-income donors living in states with a state
income tax will be unaffected by the new phase-out rules.
Example
2
But
what if the donors reside in a state like Florida or Wyoming with no state
income tax, and own their home(s) free and clear, so they have no mortgage
income tax deduction. Assume the same couple with AGI of $1 million whose only
other itemized deduction is property taxes of $50,000. Their itemized
deductions will be reduced by the same amount as in Example 1, $21,000. If they
make a charitable contribution of $100,000, their total itemized deductions of
$150,000 will be reduced to $129,000. However, had they not made the gift,
their property taxes of $50,000 would have been reduced by the same $21,000 to
$29,000. Again, even for donors residing
in a state with no income taxes and who have no mortgage interest expense, the
offset applies to the nondiscretionary itemized deduction for property tax,
meaning that the charitable deduction is not affected by the phase-out.
So
who would be affected? Can we conjure a situation in which the phase-out from
the new tax act would reduce a donor’s tax incentive to make a charitable gift?
Example
3
Assume
the same couple with an AGI of $1 million lives in a state with no income tax
and pays neither home mortgage interest nor property taxes because they rent
the dwelling they occupy in a retirement community. Their only itemized
deduction is a charitable gift of $100,000. In this situation, the reduction of
$21,000 would offset the charitable deduction of $100,000, meaning that only
$79,000 of the $100,000 gift will actually be deductible.
