Occasionally, one of our clients will come to us concerned about the itemized deduction phase-out, particularly as it affects their charitable giving. The phase-out rule reduces an itemized deduction’s tax benefit. Technically, the charitable deduction, as an itemized deduction, is subject to the phase-out rule.
Accordingly, high-income donors should understand the phase-out rule in the context of charitable giving – a context in which the rule is often misunderstood. The good news is that the tax benefit from charitable giving is not reduced for many, if not most, high-income taxpayers.
Understanding the Rule
Before getting into a few helpful examples, let’s look at the rule itself. Section 68 of the Internal Revenue Code reduces, or “phases-out,” allowable itemized deductions for certain high-income taxpayers. But not all itemized deductions are created equal for phase-out purposes. To conceptualize why, you can group expenses generating an itemized deduction into two types – “inevitable” and “voluntary.” (For purposes of this article it’s assumed that a taxpayer’s total inevitable expenses exceed the taxpayer’s standard deduction.)
Inevitable expenses include state income taxes, interest generated by qualified mortgages, and real estate taxes. These are inevitable because, if you live in a state with an income tax and you are a high-income taxpayer, you are going to incur state income taxes that, inevitably, generate an itemized deduction for federal income tax purposes. Similarly, if you own a principal residence, inevitably you are going to pay real estate taxes that, like state income taxes, birth an itemized deduction. Mortgage interest is an inevitable expense for those of us sharing ownership of our home with a financial institution.
So what do inevitable expenses share in common? They are expenses that, given your present facts and circumstances, you are certainly going to pay, or face not so pleasant legal consequences.
Not so in the case of voluntary expenses. (Let’s not engage in a discussion of the “voluntary” nature of choosing to live in a high-income tax rate state, or to purchase a residence, and assume that these choices have been made, and you aren’t going to change those decisions on an annual basis because you may lose the tax benefit of some of your expenses that generate itemized deductions.)
One truly voluntary expenditure giving rise to an itemized deduction is a charitable gift. Each year, you choose whether or not to support charitable organizations. That decision might just be swayed by your understanding of Section 68 and its impact on the tax benefits you receive as a result of your charitable gifts.
Having defined two types of expenses that generate itemized deductions, and highlighting the fact that your charitable giving choices might be influenced by Section 68, let’s turn to the mechanics.
Impact on Your Charitable Deduction
Section 68 limits the allowable itemized deductions certain high-income taxpayers can claim by phasing-out the aggregate amount of itemized deductions that can be claimed on a tax return. For 2016, the Section 68 phase-out rule applies to taxpayers whose adjusted gross income (AGI) is greater than $311,300 if married filing a joint return, $259,400 if filing as single, $285,350 if filing as head of household, or, in general, $155,650 if married filing a separate return (these are the “applicable amounts”).
Section 68 reduces otherwise allowable itemized deductions by three percent of the amount AGI that exceeds the applicable amount for a given filing status. However, the phase-out never exceeds 80 percent of your total itemized deductions. In other words, the phase-out is the lesser of three percent of the excess of a taxpayer’s AGI over the applicable amount or 80 percent of total itemized deductions.
Example 1: Taxpayer files as single, has an AGI of $1 million and $600,000 of itemized deductions, prior to application of the Section 68 phase-out rules. Taxpayer’s itemized deduction phase-out is $22,218, calculated as $1 million of AGI, minus $259,400 (single taxpayer applicable amount) equals $740,600, times 3 percent (the phase-out percentage) equals $22,218. Allowable itemized deductions for Taxpayer after application of the Section 68 rules are $577,782 (total $600,000 itemized deductions less $22,218 phased-out).
Example 2, which builds on Example 1, illustrates why Taxpayer lost the benefit of their inevitable expenses, but not their voluntary expenses.
Example 2: Same facts as in Example 1, but consider that Taxpayer’s itemized deductions consist of $100,000 paid for state income and real estate taxes (inevitable expenses) and $500,000 attributable to charitable gifts (voluntary expenses). Given this, we can say Taxpayer received the full tax benefit from their $500,000, voluntary expenses – their charitable gifts.
Example 3: If in Example 2 Taxpayer made no charitable gifts – that is, Taxpayer had no voluntary expense that gave rise to an itemized deduction – their total itemized deductions before the Section 68 phase-out rules are applied would be $100,000, rather than $600,000. In such a case, after the phase-out, Taxpayer’s allowable itemized deductions are $77,782 (total itemized deductions, $100,000, less $22,218 phased-out, leaves an allowable itemized deduction of $77,782).
In Example 3, one hundred percent of Taxpayer’s $77,782 allowable itemized deductions are attributable to inevitable Taxpayers expenses – expenses Taxpayer could not (at least without legal consequences) avoid – income and real estate taxes. As a result, should Taxpayer choose to voluntarily incur an expense by making a $500,000 charitable gift of cash to a public charity, Taxpayer increases their allowable itemized deductions to $577,782. An additional itemized deduction phase-out does not occur because of the Taxpayer’s voluntary decision to make charitable gifts, and Taxpayer receives the full tax benefit of making the gifts.
Pulling it All Together
As the examples show, inevitable expenses should be considered as subject to the Section 68 phase-out rule before the voluntary itemized deduction attributable to charitable gifts. Therefore, most, if not all high-income charitable taxpayers will see the full tax benefit from their charitable gifts, irrespective of the Section 68 itemized deduction phase-out.
The exception to this is for those taxpayers who have few, if any, inevitable expenses giving rise to itemized deductions. However, even taxpayers residing in low rate (or no) income tax states may very well have significant itemized deductions for inevitable expense items such as real estate taxes and mortgage interest.
A final caveat. This article discusses only federal income taxes. Those subject to state income taxes may be subject to state rules that phase-out deductions for state tax purposes. Such rules may decrease the state income tax benefit from charitable giving. For this reason, because every taxpayer’s fact and circumstances are different, and because the federal and State tax rules are complex and apply to different taxpayers in different ways, before making any significant financial decision that may impact your tax liability, be sure to consult your tax professional so they can apply the law to your unique facts and circumstances.
Are you a Trust and Estate Attorney or an Investment Advisor? You can download our free prospectus to see what sets us apart from other donor-advised funds.
Are you a donor looking for the most tax advantaged way to give to the charities you care about? Know the 6 Key Reasons to Use a Donor-Advised Fund.