The IRS has released much-anticipated temporary and proposed regulations on the capitalization of costs incurred for tangible property. They impact how virtually any business writes off costs that repair, maintain, improve or replace any tangible property used in the business, from office furniture to roof repairs to photocopy maintenance and everything in between. They apply immediately, to tax years beginning on or after January 1, 2012.

These so-called “repair regulations” are broad and comprehensive. They apply not only to repairs, but to the capitalization of amounts paid to acquire, produce or improve tangible property. They are intended to clarify and expand existing regulations, set out some bright-line tests, and provide some safe harbors for deducting payments.

The regulations are an ambitious effort to address capitalization of specific expenses associated with tangible property. The regulations affect manufacturers, wholesalers, distributors, and retailers—everyone who uses tangible property, whether the property is owned or leased. The rules provide a more defined framework for determining capital expenditures.

Most taxpayers will have to make changes to their method of accounting to comply with the temporary regulations and will need to file Form 3115. Taxpayers who filed for a change of accounting method following the issuance of the 2008 proposed regulations will probably have to change their accounting method again.

The IRS has promised to issue two revenue procedures that will provide transition rules for taxpayers changing their method of accounting, including the granting of automatic consent to make the change. The regulations require taxpayers to make a Code Sec. 481(a) adjustment; this means that taxpayers will have to apply the regulations to costs incurred both prior to and after the effective date of the regulations.

The new regulations provide rules for materials and supplies that can be deducted, rather than capitalized. The rules provide several methods of accounting for rotable and temporary spare parts, and allow taxpayers to apply a de minimis rule so that they can deduct materials and supplies when they are purchased, not when they are consumed.

Costs to acquire, produce or improve tangible property must be capitalized. The regulations address moving and reinstallation costs, work performed prior to placing property into service, and transaction costs. Generally, costs of simply removing property can be deducted, but costs of moving and then reinstalling property may have to be capitalized.

To determine whether a cost incurred for property is an improvement, it is necessary to determine the unit of property. Generally, the larger the unit of property, the easier it is to deduct expenses, rather than have to capitalize them. The regulations provide detailed rules for determining the unit of property for buildings and for non-building tangible property. For buildings, the IRS identified eight component systems as separate units of property, requiring more costs to be capitalized. However, the new rules also provide for deducting the costs of property taken out of service, by treating the retirement as a disposition.

The new regulations require virtually every business to review how repairs, maintenance, improvements and replacements are handled for tax purposes, with both mandatory and optional adjustments made to past treatment as appropriate.

Please feel free to call this office for a more targeted explanation of how these new regulations impact your business operations.

The fate of the employee-side payroll tax cut along with a host of tax extenders and other expired provisions could be decided in coming weeks. A conference committee of House and Senate members is negotiating a full-year extension of the payroll tax cut and could add some or all of the tax extenders to a final package. Lawmakers also could extend the payroll tax cut without acting on any tax incentives.

Payroll tax cut

The Temporary Payroll Tax Cut Continuation Act of 2011 extended the employee-side OASDI tax cut through the end of February 2012. The employee-share of OASDI taxes is 4.2 percent for the two-month period, rather than 6.2 percent. The employer-share of OASDI taxes remains at 6.2 percent for the two month period. Self-employed individuals also benefit from a two percentage point reduction in OASDI taxes.

Unless extended, the employee-share of OASDI taxes is scheduled to revert to 6.2 percent after February 29, 2012. The White House and the leaders of the two parties in Congress agree that the payroll tax cut should be extended a full-year. They disagree, however, how to pay for the extension; even if it should be paid for at all.

Congress could extend the two-month payroll tax cut through the end of 2012 without paying for it. The 2011 payroll tax cut was unfunded. Congress appropriated to the Social Security trust funds amounts equal to the reduction in payroll tax revenues. The 2011 payroll tax cut was estimated by the Congressional Budget Office cost approximately $111 billion. Extending it through the end of 2012 is estimated to cost just as much if not more.

House Republicans reportedly have proposed a number of revenue raisers to offset the cost of extending the payroll tax cut through the end of 2012. One GOP proposal would extend the current pay freeze for employees of the federal government. Another GOP proposal would require higher-income individuals to pay increased Medicare premiums.

One possible revenue raiser, increasingly under discussion by Democrats, is a change in the taxation of so-called carried interest. Current law generally taxes carried interest as capital gains and not as ordinary income. Past efforts to change the tax treatment of carried interest have failed to pass Congress.

Extenders

The so-called tax extenders, popular but temporary tax provisions, expired at the end of 2011. Many taxpayers are surprised to learn that their particular tax break, whether it be the state or local sales tax deduction, the teachers’ classroom expense deduction, or the research tax credit, are temporary. The extenders have been routinely revived many times in the past. This year, however, could be different. Faced with record federal budget deficits, lawmakers may decide to extend only some of the expired provisions.

President Obama’s FY 2013 proposals

President Obama is expected to release his fiscal year (FY) 2013 federal budget proposals in early February, which will reignite debate over the Bush-era tax cuts. President Obama is expected to urge Congress to allow the Bush-era tax cuts to expire after 2012 for higher-income taxpayers, which President Obama defines as individuals earning more than $200,000 or families earning more than $250,000. In recent weeks, there has been speculation that President Obama may revisit those definitions in his FY 2013 budget, possibly raising the amounts.

Few Capitol Hill observers expect Congress to take any action on the Bush-era tax cuts before the November elections. Instead, Congress may take up some of President Obama’s other proposals. As in past budgets, President Obama will likely propose to extend some energy tax breaks for individuals and businesses, extend tax incentives for education and provide some targeted-tax breaks to businesses. President Obama has also promised to introduce proposals to encourage U.S. companies to “insource” jobs at home.

On some issues, such as energy and education, lawmakers may find common ground but negotiations are likely to go down to the wire. Our office will keep you posted of developments.

If you have any questions about the payroll tax cut, tax extenders or the various tax proposals under discussion, please contact our office.

The IRS reopened its offshore voluntary disclosure program in early 2012 in response to what the government described as strong interest among taxpayers. The reopened program, the third of its type in recent years, encourages taxpayers with unreported foreign accounts to make full disclosures in exchange for a reduced penalty framework. Like its predecessors, the terms and conditions of the reopened program are very complex. The IRS has promised to provide more details. In the meantime, the prior offshore disclosure programs are guides to how the IRS intends to implement the third, reopened program.

Previous disclosure programs

The IRS launched two previous offshore disclosure initiatives: one in 2009 and another in 2011. Both programs offered reduced penalties in exchange for full disclosure. In early 2012, the IRS reported it received 33,000 voluntary disclosures from the 2009 and 2011 offshore initiatives. The government has collected over $4.4 billion from the 2009 and 2011 programs. The IRS predicted it will collect more revenue as it continues to work cases.

Reopened program

The reopened program operates very similarly to the 2009 and 2011 programs but with some key differences. The previous programs were temporary. The 2011 program ended in mid-September 2011. The reopened program has no set end date. The IRS cautioned, however, that it could close the program at some future date. The decision to end the program is solely at the discretion of the IRS.

The reopened program requires taxpayers to file all original and amended tax returns and include payment for back-taxes and interest for up to eight years as well as pay accuracy-related and/or delinquency penalties. Additionally, taxpayers must pay a penalty of 27.5 percent of the highest aggregate balance in foreign bank accounts/entities or value of foreign assets during the eight full tax years prior to the disclosure. In comparison, the highest penalty in the 2011 program was 25 percent. IRS officials have said that the penalty was increased because the agency does not want to reward taxpayers who did not participate in the 2009 or 2011 disclosure programs because they anticipated that a future penalty would be lower.

In limited circumstances, taxpayers may qualify for a 12.5 percent penalty or a five percent penalty. Generally, taxpayers whose offshore accounts or assets did not surpass $75,000 in any calendar year may qualify for the 12.5 percent penalty.

The requirements for the five percent penalty are very narrow. The IRS has explained that taxpayers must meet four conditions: (1) The taxpayer did not open or cause the account to be opened; (2) the taxpayer exercised minimal, infrequent contact with the account, for example, to request the account balance, or update account holder information such as a change in address, contact person, or email address; (3) except for a withdrawal closing the account and transferring the funds to an account in the United States, the taxpayer did not withdraw more than $1,000 from the account in any year for which the taxpayer was non-compliant; and (4) the taxpayer can show that all applicable U.S. taxes have been paid on funds deposited to the account (only account earnings have escaped U.S. taxation).

The penalty amounts in the reopened program are not set in stone, the IRS cautioned. It may eventually increase penalties in the program for all or some taxpayers or defined classes of taxpayers.

Quiet disclosures

One goal of the three programs is to caution taxpayers against so-called “quiet disclosures.” A quiet disclosure occurs when a taxpayer files an amended return and pays any tax delinquency without making a formal voluntary disclosure. The IRS warned taxpayers making quiet disclosures that they risked being sanctioned to the fullest extent allowed by law.

Critics

The offshore disclosure programs were not without their critics. The National Taxpayer Advocate recently told Congress that the IRS should streamline what is a very complicated process. The National Taxpayer Advocate also reported that IRS examiners were assuming that all violations were willful unless a taxpayer presented evidence to the contrary. It is possible that the IRS may revisit some of the terms and conditions of the reopened program in light of the National Taxpayer Advocate’s report.

If you have any questions about the reopened offshore voluntary disclosure program, please contact our office.

Taxpayers with children should be aware of the numerous tax breaks for which they may qualify. Among them are: the dependency exemption, child tax credit, child care credit, and adoption credit. As they get older, education tax credits for higher education may be available; as is a new tax code requirement for employer-sponsored health care to cover young adults up to age 26. Employers of parents with young children may also qualify for the child care assistance credit.

Dependency Exemption

In addition to the personal exemption an individual taxpayer may take for him or herself to reduce taxable income (Line 42 on Form 1040), that taxpayer may also take an exemption for each qualifying dependent who has lived with the taxpayer for more than half of the tax year. A dependent may be a natural child, step-child, step-sibling, half-sibling, adopted child, eligible foster child, or grandchild, and generally must be under age 19, a full-time student under age 24, or have special needs. The amount of the exemption is the same as the taxpayer’s personal exemption, $3,700 for the 2011 tax year and $3,800 for the 2012 tax year.

Child Tax Credit

Parents of children who are under age 17 at the end of the tax year may qualify for a refundable $1,000 tax credit. The credit is a dollar-for-dollar reduction of tax liability, and may be listed on Line 51 of Form 1040. For every $1,000 of adjusted gross income above the threshold limit ($110,000 for married joint filers; $75,000 for single filers), the amount of the credit decreases by $50.

Child and Dependent Care Credit

If a taxpayer must pay for childcare for a child under age 13 in order to pursue or maintain gainful employment, he or she may claim up to $3,000 of his or her eligible expenses for dependent care. If one parent stays home full-time, however, no child care costs are eligible for the credit.

Adoption Credit

Taxpayers who have incurred qualified adoption expenses in 2011 may claim either a $13,360 credit against tax owed or a $13,360 income exclusion if the taxpayer has received payments or reimbursements from his or her employer for adoption expenses. For 2012, the amount of the credit will decrease to $12,650, and in 2013 to $5,000.

Higher Education Credits

There are two education-related credits available for 2012: the American Opportunity credit and the lifetime learning credit. The American Opportunity credit amount is the sum of 100 percent of the first $2,000 of qualified tuition and related expenses plus 25 percent of the next $2,000 of qualified tuition and related expenses, for a total maximum credit of $2,500 per eligible student per year. The credit is available for the first four years of a student's post-secondary education. The credit amount phases out ratably for taxpayers with modified AGI between $80,000 and $90,000 ($160,000 and $180,000 for joint filers). The lifetime learning credit is equal to 20 percent of the amount of qualified tuition expenses paid on the first $10,000 of tuition per family. The phaseout for 2012 ranges from $52,000 to $62,000 ($104,000 to $124,000 for joint filers). Parents also find tax relief in saving for college though Coverdell accounts, section 529 plans and specified U.S.. savings bonds.

Extended Health Care Coverage

Effective since September 23, 2010, the new health care law requires plans to provide coverage for children until they attain age 26. Further, effective on or after March 30, 2010, children under the age of 27 are considered dependents of a taxpayer for purposes of the general exclusion from income for reimbursements for medical care expenses of an employee, spouse, and dependents under an employer-provided accident or health plan. Therefore, a plan must provide coverage to a child who is still a dependent up to age 26; but can do so up to age 27 without income tax consequences. A child includes a son, daughter, stepson, or stepdaughter of the taxpayer; a foster child placed with the taxpayer by an authorized placement agency or by judgment, decree, or other order of any court of competent jurisdiction; and a legally adopted child of the taxpayer or a child who has been lawfully placed with the taxpayer for legal adoption.

Child Care Assistance Credit (for businesses)

Employers may take up to $150,000 of the eligible costs of providing employees with child care assistance as tax credit. These costs may include a portion of the costs of acquiring, constructing, improving, and operating a child care facility.

If you have any questions about these provisions and how they may benefit you, please contact our office.

The Treasury Department is authorized to offset a taxpayer’s tax refund to satisfy certain debts. A spouse who believes that his or her portion of the refund should not be used to offset the debt that the other spouse owes may request a refund from the IRS.

Offset

If an individual owes money to the federal government because of a delinquent debt, the Treasury Department’s Financial Management Service (FMS) can offset that individual's tax refund (and certain other federal payments) to satisfy the debt. The debtor will be notified in advance of the offset.

A taxpayer’s refund may be reduced by FMS and offset to pay:

• Past-due child support
• Federal agency non-tax debts
• State income tax obligations, or
• Certain unemployment compensation debts owed a state.

FMS advises taxpayers by written notice of an offset. FMS has explained that the notice will reflect the original refund amount, the taxpayer’s offset amount, the agency receiving the payment, and the address and telephone number of the agency. FMS will notify the IRS of the amount taken from your refund.

Form 8379

If a taxpayer filed a joint return and is not responsible for the debt of his or her spouse, the taxpayer may request his or her portion of the refund by filing Form 8379, Injured Spouse Allocation, with the IRS. Form 8379 may be filed with the original return or by itself after the taxpayer is aware of the offset.

The IRS has instructed taxpayers filing Form 8379 by itself to attach a copy of all Forms W-2 and W-2G for both spouses, and any Forms 1099 showing federal income tax withholding to Form 8379. Failure to attach these items may result in a delay in processing by the IRS.

The IRS has reported on its website that it generally processes Forms 8379 that are filed after a joint return has been filed in approximately eight weeks. The timeframe for processing a Form 8379 that is attached to a joint return is approximately 11 weeks (14 weeks if the joint return is filed on paper).

As an individual or business, it is your responsibility to be aware of and to meet your tax filing/reporting deadlines. This calendar summarizes important tax reporting and filing data for individuals, businesses and other taxpayers for the month of February 2012.

February 1

Employers. Semi-weekly depositors must deposit employment taxes for payroll dates January 25–27.

February 3

Employers. Semi-weekly depositors must deposit employment taxes for payroll dates January 28–31.

February 8

Employers. Semi-weekly depositors must deposit employment taxes for payroll dates February 1–3.

February 10

Employees who work for tips. Employees who received $20 or more in tips during November must report them to their employer using Form 4070.

Employers. Semi-weekly depositors must deposit employment taxes for payroll dates February 4–7.

February 15

Employers. Semi-weekly depositors must deposit employment taxes for payroll dates February 8–10.

Monthly depositors. Monthly depositors must deposit employment taxes for payments in January.

February 17

Employers. Semi-weekly depositors must deposit employment taxes for payroll dates February 11–14.

February 23

Employers. Semi-weekly depositors must deposit employment taxes for payroll dates February 15–17.

February 24

Employers. Semi-weekly depositors must deposit employment taxes for payroll dates February 18–21.

February 29

Employers. Semi-weekly depositors must deposit employment taxes for payroll dates February 22–24.

March 2

Employers. Semi-weekly depositors must deposit employment taxes for payroll dates February 25–28.

March 7

Employers. Semi-weekly depositors must deposit employment taxes for payroll dates February 29–March 2.

Just because you're married doesn't mean you have to file a joint return. This is a common misconception along with thinking that "married filing separately" applies to couples who are separated or seeking a divorce. As a married couple, you have two choices: file a joint return or file separate returns. Naturally, there are benefits and detriments to each and your tax advisor can chart the best course of action for you.

Traditional treatment

Historically, the tax laws reward marriage. Married couples are eligible for many incentives. For example, they can make tax-free gifts of up to $26,000 (for 2009) to the same individual ($13,000 from each spouse). Single taxpayers can only make tax-free gifts up to $13,000 to the same person. Married couples also have a larger home sale exclusion: they can exclude up to $500,000 in gain from the sale of their home. Single taxpayers are limited to an exclusion of up to $250,000.

Moreover, single individuals no longer have a leg-up when it comes to the standard deduction because of the "marriage penalty." The standard deduction for married couples is now twice the deduction for single taxpayers. For 2009, the standard deduction for married taxpayers filing jointly is $11,400 (for single taxpayers, the standard deduction for 2009 is $5,700). Married taxpayers filing separately also individually take a standard deduction of $5,700 for 2009.

Important credits and deductions

Credits and deductions significantly lower your tax bill. Unfortunately, some credits and deductions are lost unless you file a joint return. These include:

-- HOPE Scholarship credit (temporarily renamed the American Opportunity Education credit for 2009 and 2010);

-- Lifetime Learning credit;

-- Dependent care credit;

-- Earned Income Tax Credit;

-- Adoption credit; and the

-- Deduction for student loan interest.

If these credits and deductions are valuable to you, and you are married, you'll have to file a joint return.

When to file separately

Two events may make you decide to file a separate return:

--Your personal itemized deductions are very high; or

--You do not want to be legally responsible for your spouse's tax liability.

Let's look at the second one first. When a married couple files a joint return they are both legally liable for any tax owed to the government. This is a hard and fast rule. The moment you sign your name to your joint return, you are just as liable for the tax as your spouse. The IRS can come after both of you or just one for the full amount of the tax liability.

Getting out of joint liability is not easy. If you did not know about errors or false statements on your return, you can petition for relief under the innocent spouse rules. The IRS may excuse you from joint liability but the process takes a long time. If you do not want to be liable for your spouse's taxes, don't sign a joint return.

Sometimes one spouse has a large amount of itemized deductions. This often occurs because of illness. Medical expenses are deductible only to the extent that they exceed 7.5 percent of adjusted gross income. If only one spouse had the majority of the couple's medical expenses, it may be easier to overcome the 7.5 percent threshold when only one spouse's income is reported on the return.

Employee business expenses and casualty losses, such as damage from a natural disaster to property owned by one spouse, also are common triggers for filing separately. If these expenses are high, they may reduce your tax bill if reported on a separate return.

Itemizing

If you decide to file separate returns, you and your spouse must itemize deductions or take the standard deduction. You cannot itemize deductions on your return and your spouse take the standard deduction on his return.

Weighing the pros and cons of filing separately is complex and unique to each couple. Lots of other factors, such as children, Social Security and pension benefits, and residency, can make a difference. Contact this office for help in deciding which filing status will maximize your tax breaks and minimize your tax bill.

The IRS has some good news for you. Under new rules, you may be able to gain a partial tax break on the full $250,000 capital gain exclusion ($500,000 if you file jointly with your spouse), even if you haven't satisfied the normal "two out of five year test" necessary to gain that tax benefit. You may qualify for an exception.

The IRS has some good news for you. Under generous tax rules, you may be qualify for a partial tax break on the full $250,000 capital gain exclusion ($500,000 if you file jointly with your spouse), even if you haven't satisfied the normal "two out of five year test" necessary to gain that tax benefit. You may qualify for an exception. However, under new rules established in the Housing and Economic Recovery Act of 2008, gain from the sale of a principal residence will no longer be excluded from gross income under Code Sec. 121 for periods that the home was not used as a principal residence.

Traditional approach

Homeowners who have owned or used their principal residence for less than two of the five years preceding the sale or exchange, or who have excluded gain from another sale or exchange during the last two years, may qualify for the reduced maximum exclusion if the sale or exchange is due to a change in place of employment, health, or unforeseen circumstances. The reduced exclusion is equal to the regular $250,000 ($500,000 for joint filers) exclusion amount multiplied by the number of days of ownership and use over the two-year period.

Reduced home sale exclusion

The 2008 Housing Act changed the homesale exclusion for home sales after December 31, 2008. Under the 2008 Housing Act, gain from the sale of a principal residence will no longer be excluded from a homeowner's gross income for periods that the home was not used as a principal residence (i.e. "non-qualifying use"). A period of absence generally counts as qualifying use if it occurs after the home was used as the principal residence.

In effect, the rule prevents the use of the Code Sec. 121 exclusion of gain from the sale of a principal residence of up to $250,000 ($500,000 for joint filers) for appreciation attributable to periods after 2008 that the home was used as a vacation home or rental property before being used as a principal residence.

Traditionally, the IRS was very reluctant to dispense people from the strict home exclusion rules. The IRS could make an exception based on a hardship or an unforeseen circumstance, but the criteria for these exceptions weren't very clear. The exceptions weren't always uniform. Now, the government has clarified the exceptions and significantly expanded them.

Criteria

Health reasons You may exclude gain if you sell your residence because of ill health. If your physician recommends a change in residence, the IRS explained that would be sufficient grounds to qualify for the exclusion. This important exclusion is also available if your spouse, the co-owner of your home or a household member must relocate for health reasons.

Change in employment If you must relocate because of a change in employment, you may be able to exclude gain from the sale of your residence. Your new place of employment must be at least 50 miles farther away. Like the special exception for health reasons, you can qualify for this exception if you, your spouse, another co-owner of your home or a household member must move for this reason.

Unforeseen circumstances This exception is very broad and can be confusing. Before you think you qualify under this exception, seek advice from a tax professional. Here are some events that qualify as an unforeseen circumstance:

--(1) Death;

--(2) Divorce or separation;

--(3) Unemployment;

--(4) Multiple births from the same pregnancy;

--(5) Moving closer to care for a close relative who is ill;

--(6) Condemnation or seizure of your home;

--(7) War or terrorism; and

--(8) Natural or man-made disasters.

In addition to these exceptions, the IRS has discretion to determine other circumstances as unforeseen. Like the health and change in employment exceptions, you may be eligible for an exclusion based on unforeseen circumstances if you, your spouse, the co-owner of your home, or a household member satisfies one of these criteria.

Professional guidance

Before you think you qualify under any of the exceptions, seek advice from a tax professional. For example, to qualify for the unemployment exception, you must be eligible for unemployment compensation. To come under the exception that accommodates moving to take care of a close relative, careful medical records and personal logs should be maintained. By gathering the proper proof in advance, major headaches with the IRS may be avoided.

As a business owner you have likely heard about the tax advantages of setting up a retirement plan for you and your employees. Many small business owners, however, have also heard some of the horror stories and administrative nightmares that can go along with plan sponsorship. Through marketing information that you receive, you may have learned that a simplified employer plan (SEP) is a retirement plan you can sponsor without the administrative hassle associated with establishing other company plans, including Keoghs.

Evaluate your needs

Getting started

Once you establish a SEP, the administrative requirements are simple. The IRS and each employee must be sent an annual statement about SEP contributions made on behalf of the employee and the value of that employee's accounts at the beginning and the end of the year. This responsibility can be handled by the financial institution for a small fee.

If you want assistance in establishing a SEP for your business, contact us for further information.

U.S. citizens and resident aliens working abroad may exclude up to $91,400 of their foreign earned income for 2009. Additionally, expatriates may deduct or exclude their foreign housing costs in excess of a base amount. The housing exclusion is for reimbursed expenses while the deduction is for unreimbursed costs.

Earned foreign income

Before being able to claim these exclusions, you must meet some primary requirements. Foreign earned income is an individual's earned income from foreign sources during the time period that he or she has a foreign tax home and either satisfies the bona fide or physical residence test.

Tax home

Your tax home also must be in a foreign country. Generally, the IRS and the courts hold that your principal place of business or employment is your tax home.

Status

Finally, you must be a:

U.S. citizen who is a bona fide resident of a foreign country or countries for a continuous time period including the entire tax year;

U.S. resident alien who is a citizen or national of a country having an income tax treaty with the U.S. and who satisfies the continuous residency requirement; or

U.S. citizen or resident alien physically present in a foreign country or countries for a minimum of 330 days during any consecutive 12 month period.

Higher-income individuals whose adjusted gross income (AGI) exceeds a threshold level must reduce the amount of their otherwise allowable itemized deductions.

Higher-income individuals whose adjusted gross income (AGI) exceeds a threshold level must continue to reduce the amount of their otherwise allowable itemized deductions.

Under the limitation, your total itemized deduction amount (with the exceptions, noted below) is reduced by the lesser of:

-- Three percent of the amount of your AGI in excess of the threshold amount for the tax year (adjusted for inflation); or

-- 80 percent of the itemized deductions otherwise allowable for the tax year.

For the 2009 tax year, the inflation-adjusted threshold amount is $166,800 for married taxpayers filing jointly, single taxpayers, and heads of households; and $83,400 for married taxpayers filing separately

For purposes of this limitation, itemized deductions do not include the deduction relating to medical expenses, the deduction for investment interest expenses, casualty or theft losses, or allowable wagering losses.

In computing the amount of the reduction of total itemized deductions, all other limitations applicable to those deductions, such as the 2-percent floor for miscellaneous itemized deductions, are applied first, and then the otherwise allowable total amount of deductions is reduced pursuant to this provision.

Example

For 2009, Smith is single and has AGI of $250,000 and $110,000 of itemized deductions, which include miscellaneous itemized deductions of $15,000 and a theft loss deduction of $20,000.

The theft loss is excluded in determining itemized deductions for this purpose, and the miscellaneous itemized deductions are first reduced by the 2-percent floor ($250,000 x 2% = $5,000). Therefore, otherwise allowable itemized deductions (excluding the theft loss) are $85,000 ($90,000 - $5,000). This amount is further reduced by $2,496 (3% x ($250,000 - $166,800). As such, total net deductions equal $82,504. The theft loss amount is added to this, for a total allowed itemized deduction amount of $102,504. Thus, Smith's itemized deductions are reduced by a total of $7,496 because of the size of his income (which in the 33% income tax bracket will cost him $2,473.68).