Gift Now or Not? Impact of Pease Limit on Charitable Deductions

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In the final days of 2012, we have only one tax certainty—no preference is safe, and the deduction for charitable donations that your high-net-worth clients rely on to reduce their tax rates is no exception. While many of your clients are left wondering if they should accelerate charitable giving into 2012 to ensure that they reap the benefits of the current deduction, others are looking ahead to an entirely different scenario. If leaders in Washington are unable to find middle ground, we’ll go over the so-called fiscal cliff, and a primary consequence of that leap may be higher income tax rates for all. The question then remains: how do you help clients plan for charitable giving when the deduction could be sharply limited in 2013 or become more valuable than ever?

The Target: Tax Deductions for Charitable Giving

While potentially steep increases in tax rates across the board tend to take center stage in the fiscal cliff news coverage, impending limits on itemized tax deductions can be equally important for many of your high net worth clients. The Pease limitation on itemized deductions is scheduled to be reinstated effective January 1, 2013, along with pre-Bush era tax rates. This limitation would institute a phaseout of itemized deductions—including deductions for charitable giving, mortgage interest, and state and local taxes—for taxpayers with adjusted gross income above a certain threshold level (President Obama’s proposals would start the phaseout at about $261,450 for a married couple, and $209,150 for individuals, though, absent compromise, the threshold that will be automatically reinstated is much lower—$174,450).

For taxpayers with income above the threshold amount for the year, the itemized deduction limit would be equal to the lesser of (a) 3% of adjusted gross income (AGI) above the threshold or (b) 80% of the itemized deductions that would otherwise be allowed.

In addition to the threat posed by the Pease limitation, both parties have pushed for caps on itemized deductions as part of a broader budget compromise: President Obama favors capping the charitable deduction at 28% for families earning over $250,000, while GOP proposals have advocated a general fixed dollar limit on itemized deductions.

For taxpayers who do not itemize deductions or meet the income thresholds, these limitations would likely have little direct impact on their tax bills. The impact of limiting itemized deductions could be dramatic, however, for those clients accustomed to making large charitable gifts each year.

The Planning Dilemma

If absolutely no compromise is reached in Congress, whether in the coming weeks or early in 2013, tax rates will increase and itemized deductions will be sharply limited for upper-middle class and high-net-worth clients. Clients looking to plan for this worst-case scenario should consider moving any large charitable gifts into 2012, whether through an outright donation or a donor advised fund (DAF) that pulls the deduction into the current year even if the gift is not made until the future.

If income tax rates are allowed to remain at 2012 levels, but deduction limitations are imposed to make up for the revenue shortfall this could cause, clients would likewise be better off accelerating gifts into 2012 to take advantage of the certainty of today’s deduction.

However, in the unlikely event that tax rates are allowed to increase, but rules for itemizing deductions are left in their current form, charitable gifts would become much more valuable in 2013 because they would shelter income that would otherwise be taxed at the higher rates.

The bottom line is that we do not know what will happen in 2013, but the time is upon us to ensure that clients are advised of the possible outcomes so that they can make an educated decision as to the amount of risk they’re willing to accept as the fiscal cliff deadline approaches. 

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