3% Itemized Deduction Reduction, commonly known
as the 3% Phaseout Rule, can limit your Tax Deductions!


New Phaseout Limit
Beginning in 2006, the overall limit on certain itemized deductions
was gradually eliminated.  Under this phaseout rule, the limit
on itemized deductions is reduced by one-third for 2006.  These
reductions will continue until 2009.  For 2008 and 2009, only one-third
of the amount that would have been disallowed under the pre-2006
rules win in fact be disallowed.  The reduction rules will be
completely phased out in 2010.

How To Figure the Phaseout Limit
If your itemized deductions are subject to the limit, the total of all
your itemized deductions is reduced by the smaller of the
following reduced by one-third:
 
  • 80% of your itemized deductions that are affected by
    the limit.
  • 3% of the amount by which your AGI exceeds $150,500
    ($75,250 if married filing separately).

3% Phaseout Definition
If your 2007 adjusted gross income (AGI) exceeds $156,400
($78,200 if married filing separately) some of your itemized
deductions are disallowed.  The balance of your itemized
deductions are generally reduced by 3% of the excess of your
AGI over the $156,400 (or $78,200) threshold amount.  This is
commonly known as the "3% Itemized Deduction Reduction" or
"Itemized Deduction Phaseout" rule.  There are deductions that
are not  subject to the 3% phaseout rule.  These include medical
expenses, investment interest, theft losses, gambling losses, and
casualty losses. 

If you AGI is very high, the 3% reduction applies until 80% of the
deductions are eliminated.  In other words, the reduction cannot
exceed 80% of allowable itemized deductions. 

Example:
Darrell is single and his 2007 adjusted gross income is $205,900.
Darrell has $18,000 of itemized expenses as shown below:

     Real estate taxes                   $      6,000
     Home mortgage interest            10,000
     Investment interest                          2,000
                                                              ---------------
     Total                                            $    18,000

All of Darrell's deductions except investment interest are subject
to the 3% phaseout. 

Darrell's allowable deduction would be determined as follows:

1)  AGI                                               $  205,900
     3% Threshold                              (154,400)
                                                              ---------------                                               
     Excess income                               49,500
     3 % of Excess  (49,500 x .03)         1,485.00      

2) Itemized deductions                $    18,000
     80% of expenses                            14,400 (18,000 X .80)
     Itemized deductions subject   ---------------
       to 3% phaseout                               3,600.00

3) Smaller of (1) or (2)                  $      1,485.00

4) Multiply amount by 0.6666.
     This is the amount that is
     disallowed                                 $          989.90 ($1,485 X .6666)

5) Net itemized deductions
     allowable.                                   $    17,010.10 ($18,000 - 989.90)

The smaller of the two calculations above is disallowed from
deduction.  In this case calculation 1 is $1,485.00 and calculation 2 is
$3,600.  Calculation 1 would be "phased out" of Darrell's
deduction.  Thus, Darrell would be allowed to deduct $ 17,010.10
($ 18,000 total deductions - $989.90 phaseout amount) from his
income.

You can see the 3% itemized deduction worksheet here

Note that the disallowance for itemized deductions is applied after
taking into account other limitations, such as the 2% floor for
miscellaneous itemized deductions or the 7.5% floor on medical
expenses, on your tax return.  Since there are outside the scope of
this site you should consult a tax accountant or read about them on
the IRS website.

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