Alternative Minimum tax rules

Author: David B. Matias

Published: March 10, 2005

As if taxes weren't complicated enough, they are about to get even more so for many Massachusetts residents. It is called the Alternative Minimum Tax, and it will soon impact more and more households.

By way of history, in 1978 Congress added a change to the tax code that took away many deductions for high income taxpayers. This change, called the Alternative Minimum Tax or AMT for short, was aimed at a very small group of folks who had excessively large deductions, bringing their tax burden below that of people earning far less. An extra tax was imposed on those hitting ATM standards, bringing up their tax burden and adding a sense of fairness.

AMT worked well at the time, but the problem is that AMT was never indexed for inflation. Over the years, as incomes have risen, and tax deductions have gone up, AMT is starting to hit more and more households. According to the Tax Policy Center in Washington, D.C., AMT taxes will impact nearly 19 million taxpayers in 2005, up from only 1.3 million taxpayers in 2000. A large share of those people will be from Massachusetts, mainly because of the high state income taxes and the related deductions.

So how does AMT work? AMT is a second tax calculation based on a different set of rules. In its simplest form, you must pay a 26 to 28 percent tax on your income above $40,250 for a single or head of household taxpayer, and above $58,000 for a married couple. Usually this second tax calculation will result in a lower tax than the regular income tax calculation, in which case there is no AMT effect. However, when the AMT calculation results in a higher tax than your regular income tax, you must pay the higher amount.

You can have a relatively modest income and still be impacted by AMT. If you have an equity line of credit on your home, several child tax exemptions, and claim other deductions on Schedule A, you may be hit with AMT with as little as $70,000 in combined income. Under typical circumstances, a household with a combined income of over $250,000 is likely to be paying the extra AMT tax this year.

In calculating your taxable income under AMT, many of the standard deductions from taxable income are eliminated. Exemptions for yourself, your spouse, and your dependent children are not allowed under AMT. Nor is the interest you pay on a home equity line that is not used for home improvements on your primary or secondary homes. Other eliminations include some of your medical expenses from Schedule A and all of the miscellaneous itemized deductions. The single most important elimination under AMT for Massachusetts residents is the use of state income tax and real estate taxes as a deduction from income.

AMT also has an impact on employee stock options. If you choose to exercise a set of employee stock options and hold the stock for a period of time, there is no tax consequence under the regular tax structure. Under those circumstances, the only time a tax is triggered is when you finally sell the stock. At that time you are taxed on the excess of the stock price above the price you paid to exercise the option. Under AMT, even if you don't sell the stock, you are still taxed on the difference between the price you pay for the stock and amount it is worth at the time of purchase. This can be particularly troublesome, since you could be paying a hefty tax when there is no cash from the windfall.

We are currently under some relief from the AMT tax through the end of 2005. However, starting in 2006, the exempted income for the AMT calculation drops dramatically, from $58,000 to $45,000. And since income and real estate taxes in Massachusetts tend to be a major deduction for people, we expect AMT to impact many people in the area.

The current administration has targeted tax reform as one of their current goals, which would imply simplifying the AMT calculation. Congress has also identified the matter, but rather gingerly. AMT as it currently stands will bring in an additional $1 trillion in tax revenue over the coming years and decades. To eliminate this tax revenue would require replacing it with other sources of taxes, an unpopular topic among politicians. Change may be on the way, but don't count on it.

There are several places you can go to read more about the AMT. The IRS Web site, www.irs.gov, is always a good resource, and the instructions to Form 6251 give further detail on the AMT calculation. As always, it is not a bad idea to consult a tax professional.