Deductible expenses may be classified as either above-the-line or below-the-line deductions. While above-the-line deductions reduce gross income, below-the-line or itemized deductions reduce adjusted gross income (AGI). For a taxpayer in the 39.6 percent tax bracket, each dollar of above-the-line deduction is worth $0.396 in tax savings. However, the same is not true for itemized deductions — they may produce far fewer tax savings.
Common above-the-line deductions include trade or business expenses, losses from the sale or exchange of trade, business or investment property, amounts paid for alimony, one-half of self-employment taxes, amounts contributed to an IRA, 25 percent of health insurance premiums for self-employed individuals, interest expenses related to business, and certain moving expenses.
Itemized deductions include allowable medical and dental expenses, state and local taxes, real estate taxes, investment interest expenses, qualified residence interest expense, charitable contributions and gifts, and other “miscellaneous” itemized deductions. As a class, itemized deductions are subject to two important limitations, discussed below. Specific itemized deductions may be subject to either, both, or neither these limitations.
The first limitation imposed on some itemized deductions is known as the “floor” limitation. Many itemized deductions are allowable only to the extent they exceed a particular percentage of the taxpayer’s AGI. For example, medical and dental expenses may only be deducted to the extent that they exceed 7.5 percent of AGI. Similarly, “miscellaneous” itemized deductions may be deducted, but only to the extent that their sum exceeds 2 percent of AGI. It may be possible to finesse this limitation by “bunching” itemized deductions into certain tax years. Alternatively, married taxpayers may derive more benefit from itemized deductions if they file separate returns.
The second limitation involves a phase-out for taxpayers whose AGI exceeds a threshold amount. The phaseout operates by reducing the total of itemized deductions by 3 percent of the excess of AGI over the threshold amount. In no case, however, may more than 80 percent of itemized deductions be phased-out. Medical and dental expenses, investment interest expenses, casualty losses, and wagering losses are expressly exempt from the operation of the phaseout limitation.
In sum, the viability of itemized deductions often depends upon AGI. Lower AGI will more easily permit the taxpayer to navigate both the floor and the phaseout limitations imposed on itemized deductions. Since AGI is itself defined as gross income less above-the-line deductions, one can minimize AGI by maximizing above-the-line deductions. Above-the-line deductions are most often credited with reducing ordinary income that would otherwise be subject to high tax rates. Their dual role as an inhibitor of floor and phaseout limitations might well justify their characterization as bona fide members of the increasingly rare species tax shelter.