Protecting Your Deductions

by Laura Saunders

Never mind your income-tax rate for next year—what will happen to your deductions? 

Presidential candidate Mitt Romney twice has raised the possibility of imposing caps on tax benefits to help lower tax rates. Instead of simply cutting the home mortgage-interest deduction or the write-off for charitable donations, lawmakers could allow each taxpayer one overall allowance to use as desired. Mr. Romney suggested options ranging from $17,000 to $50,000. 

President Barack Obama, meanwhile, has repeatedly suggested capping tax benefits in the administration's budget proposals. 

Of course, the outcome isn't up to either candidate but rather to Congress, which faces many tough decisions about taxes next year. Still, taxpayers trying to plan for 2013 would be wise to take a hard look at their deductions as well as their income. 

"It might be a good idea to accelerate large write-offs as well as income while the law still allows them," says Robert Gordon of Twenty-First Securities in New York, an investment firm specializing in tax strategies. 

The idea of limiting tax breaks in order to raise revenue or lower rates, or both, isn't new. Taxpayers who owe alternative minimum tax, or AMT, already lose benefits such as the deduction for state and local taxes. 

The three biggest tax breaks are for employer-provided heath insurance, the mortgage-interest deduction and retirement savings. There is real revenue in capping such breaks—and real pain for those who lose them.

"In practice, it's not an easy thing to do. These benefits are how we buy homes, get health insurance, save for retirement and give to charity," says Michael Graetz, a former top Treasury official who now is a professor at Columbia University's Law School. 

Experts note that cutting tax breaks is often highly progressive, hitting higher earners more than people earning less. That is because upper-income taxpayers are more likely to make greater use of benefits by "itemizing" deductions and listing them separately. 

According to the Tax Policy Center in Washington, only about 12% of taxpayers making less than $63,000 itemize, versus more than 90% of taxpayers earning above $150,000. The top 5% of taxpayers, who earn about $200,000 or more, on average have itemized deductions of 13% of income. 

Mr. Romney hasn't released details of which benefits he would cap or how. Elsewhere he has proposed across-the-board income-tax rate cuts of 20% (not 20 percentage points), while maintaining or lowering current rates on capital gains. He has vowed as well to preserve deductions for the middle class and avoid tax increases on it. An aide said Mr. Romney defines "middle class" as married couples with adjusted gross income up to $200,000. 

President Obama's proposed limits on tax breaks are both specific and expansive. They would affect joint filers with adjusted gross income of $250,000 or more ($200,000 for singles). In addition to cutting the value of itemized deductions to 28% or below for upper-bracket taxpayers, he calls for limiting breaks for municipal-bond interest, retirement savings, health insurance, moving expenses and more. 

Taxpayers should prepare to act later this year if the situation becomes clearer. Some possible moves: accelerating state income- and property-tax payments; paying medical-insurance premiums or other deductible costs, if they are large enough to surmount the 7.5% hurdle; and making large purchases if you will be deducting state sales tax from your federal return, assuming Congress renews this break for 2012. 

Also, pay special attention to investment-interest deductions and large charitable contributions, neither of which is currently limited by the AMT. 

Proponents of continuing the current deduction for investment interest say a cap could distort investment decisions. "Leveraged investments will suffer, because their tax rate might rise just when the deduction drops," Mr. Gordon says.

Charitable contributions, which are backed by a powerful coalition of nonprofits, are highly favored. Donations are fully deductible within certain limits, and givers also often get a full deduction for donations of appreciated stock or other property without first paying tax on the gains. 

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