How does the itemized deduction reduction affect my tax return?

As much as 80% of the tax benefits of your itemized deductions may be lost if your Adjusted Gross Income (AGI) exceeds $150,500 (for married individuals filing separate tax returns the threshold is $75,250) in 2006. Itemized deductions that otherwise would have been allowed on your tax return (excluding medical expenses, casualty and theft losses, and investment interest expense) are reduced by 3% of the amount by which your AGI, including capital gains, exceeds $150,500 in 2006. The amount that your itemized deductions can be reduced on your tax return is capped at 80%.

So, if you have an AGI of $350,500 which is $200,000 over the itemized deduction reduction threshold in 2006 and itemized deductions of $55,000, your itemized deductions are reduced by $6,000 (3% of $200,000) to $49,000 on your tax return. Put another way, your taxable income increases $6,000, and your tax increases $2,100 (35% of $6,000) on your tax return.

The disallowance of itemized deductions is applied after taking into account other limitations, such as the 2% floor for miscellaneous itemized deductions on your tax return.