Falling Into Alternative Minimum Trouble

Author: Jonathan Weisman

Published: March 7, 2004

As a reporter, I had covered every jot and tittle of last year's $350 billion tax cut, so it was with some relish that my wife loaded up our tax software last month to learn just how generous President Bush would be to us with our tax rebate.

Then came our answer: What George W. Bush had bequeathed, the alternative minimum tax had rescinded, to the tune of $2,143. The parallel income tax system, enacted more than 30 years ago to ensure the rich paid their fair share, had bitten us hard.

We are not alone in our frustration, especially in the Washington region, where the AMT will loom far larger this year than in lower-tax, lower-cost areas of the country. The Vietnam War was still boiling when an outraged Congress learned that 155 taxpayers with taxable incomes over $200,000 had paid no federal income tax in 1966. That led to the first "add-on" tax, a concept that would morph into the AMT.

Outraged lawmakers back then probably did not have in mind a reporter and his editor wife, but outrage leads to haste. When the AMT and its precursors were enacted, Congress neglected to allow its thresholds to rise with inflation, the way ordinary tax brackets do. So as incomes and costs of living rose, more and more taxpayers were ensnared.

An estimated 2.5 million households will be socked this spring by the AMT, up 400,000 from tax year 2002. That figure will rise quickly unless Congress acts, to 3.2 million in 2004, 12.1 million in 2005 and 14.9 million in 2006, according to the Internal Revenue Service's Taxpayer Advocate.

By 2008, it would cost the Treasury considerably less to repeal the ordinary income tax system than the alternative minimum tax, according to the Tax Policy Center, jointly run by the Brookings Institution and Urban Institute.

By 2010, the AMT will hit about 30 million taxpayers, most with incomes under $100,000. At that point, the AMT will be the de facto tax system for any household with income between $100,000 and $500,000, the taxpayer advocate said. At decade's end, 97 percent of married taxpayers with two or more children and income of $75,000 to $100,000 will be affected by the AMT.

Much of this exponential rise is, ironically, due to the president's tax cut. As effective ordinary tax rates fall with the tax cuts, more taxpayers will dip below the AMT's 26 percent and 28 percent tax rates. That will ensure that tens of millions of households will not see the full fruit of Congress's largess.

"The bad news before was that you had to pay higher regular taxes, so when they lowered regular taxes, you thought that was good," said Chris Sintetos, an accountant at Argy, Wiltse & Robinson in Tysons Corner. "But when the taxes came down, they dropped us below the AMT threshold."

"A lot of people are giving away what they thought they were getting," he added, "as much as 35 percent" of their tax cut.

IRS officials say they have yet to hear the outrage en masse. Congress did increase the AMT exemptions for individuals and couples in the 2001 tax cut, and widened them again in the 2003 tax cut. But those AMT "patches" expire at the end of this year, and in areas like Washington, they only went so far anyway.

Arthur Auerbach, an accountant at Goodman & Co. in Tysons, said that in past years, he saw only a handful of clients with an AMT hit. So far this tax season, the number of clients in AMT range has risen fourfold.

The reasons for Washington's woes are simple, accountants say: high taxes and escalating real estate values. Taxpayers are allowed to deduct taxes paid to state and local governments from their ordinary income taxes but not from their alternative minimum tax.

For Maryland and District households, high local income taxes alone may be enough. For the entire region, Northern Virginia included, property taxes combined with state income taxes may do the trick. Rapidly appreciating housing values have sent those taxes soaring. The pain of property taxes was once mitigated by their federal income tax deductibility. Now, it may just be another AMT trap, Auerbach said.

In short, two-income homeowners with high local taxes are now AMT bait.

And you don't have to be rich, or even what we like to call "upper middle class." The IRS taxpayer advocate recently noted that the number of taxpayers with taxable income of less than $50,000 with an AMT bill in 2001 was virtually identical to the number of those with taxable income between $475,000 and $500,000.

For my family, this all added up to a tax theater of the bizarre. We owed $700 in AMT levies for tax year 2002, but our income had actually fallen in 2003, with my wife's decision to work part time. Refinancing had lowered our mortgage-interest deduction, so we figured the AMT would not be a problem. We figured wrong, in large part because the 2003 tax cut had dipped us further into AMT territory.

Sintetos said he had a similar experience. His tax return this year was "very vanilla," he said -- no accounting shenanigans, just deductions for his charitable donations, his property taxes and his Maryland income tax. His AMT hit: $1,200.

"When you look at my return, you think, 'Wait a minute. This was supposed to hit people that are taking advantage of tax havens. You're talking to Joe Citizen and now he's fallen in.' "

The greatest irony is that the truly rich do not pay the AMT, Sintetos noted. That may be because their effective tax rate is well above the AMT's 26 percent threshold, but not necessarily. Last year's tax cut lowered the tax rates on most capital gains and dividends to 15 percent, and taxes paid on investments are not subject to the AMT test. That means the country club set, living on the 18th hole and off their investments, are paying effective federal tax rates that rival those of the man clipping the green for $25,000 a year.

"The really, really rich -- who don't even have to work for a living -- are paying 15 percent," Sintetos said. He said that for some of his clients, "I am saying, 'My God, what a windfall that tax cut was.' "

Republican and Democratic tax writers in Congress know full well the situation cannot last. The AMT cliff in 2005 -- when the number of those affected quadruples -- may be the end of the road for the current tax system. Fixing the AMT problem will be extremely expensive. Assuming that Bush's tax cuts are not allowed to expire, continuing the existing AMT "patch" would cost $658 billion over 10 years, according to the Congressional Budget Office. Full AMT repeal would exceed $1 trillion, the Tax Policy Center says.

With the federal government running record budget deficits, that may not be affordable unless repeal comes with tax increases or dramatic spending cuts. That is why the smart money says that sometime in the coming few years, no matter who is president, Republicans and Democrats will have to sit down somewhere and rewrite the entire tax code and federal budget.

The AMT will make them do it.