A Menacing Tax

The alternative minimum tax threatens millions of middle class

Author: Karin Price Mueller

Published: December 23, 2005

While the House and Senate wrangle about AMT relief, it's the middle class that's going to get lassoed, hog-tied and roasted.

AMT, or alternative minimum tax, was created decades ago to ensure the super-rich wouldn't evade taxes. But because the tax was never indexed to inflation, AMT is poised to zap as many as 3.8 million taxpayers in 2005, jumping to 20 million in 2006. And by 2010, 31 million are expected to get hit. That's nearly every middle-class family with two or more children, according to Tax Policy Center, a Washington, D.C., think tank run by the Urban Institute and Brookings Institution.

There are competing House and Senate versions of legislation to exempt many taxpayers from the AMT, a sort of second system of taxation that forces U.S. taxpayers to figure their federal income taxes twice and pay the higher amount due. The House version would exempt married couples earning less than $59,600, while the Senate bill sets the limit at $65,550. The current exemption of $58,000 expires Dec. 31.

New Jerseyans are particularly vulnerable because of high state and local taxes. In 2003, 5.9 percent of New Jerseyans owed AMT (second only to New York, where 6 percent of taxpayers were subject to AMT).

"The largest majority of taxpayers who pay the AMT tax are those in states with high income taxes and high property taxes, which certainly includes New Jersey," says Diahann Lassus, a certified public accountant and certified financial planner with Lassus Wherley Associates in New Providence. "This system has grown into a monster that is hiding in the closet of an increasing number of middle-income families, just waiting to jump out."

Right now, legislators aren't expected to agree on a solution before the holiday break, and that means the clock will run out for AMT-imperiled families.

If you're at risk, there are some things you can do to cushion the blow, although you may not be able to dodge AMT completely.

COULD IT BE YOU?

If you were safe from AMT last year, you don't automatically get a pass on your 2005 tax return. Generally speaking, families with incomes between $150,000 and $500,000 will be threatened with AMT, especially if you take a lot of deductions, exemptions or credits on your regular tax return. Under the AMT calculation, those legal, tax-saving moves are disallowed. That could mean your tax liability under the AMT calculation could be larger than your tax liability using the regular calculation, and then, you'd owe AMT.

Here are some of the items that can put you in danger:

-- Exemptions: You lose exemptions for you, your spouse and for each of your kids under AMT. The more kids you have, the more you'll feel the loss.

-- High state and local taxes: You can't deduct these under AMT.

-- High property taxes: Again, you lose the deduction under AMT. "I find it ironic that a married couple who have seen their real estate and state income taxes go through the roof, now have insult added to injury when they find out that these expenses have gotten so high that they have triggered the AMT on their federal returns," says Steve Gallo of U.S. Financial Services in Fairfield.

-- Miscellaneous itemized deductions, such as unreimbursed employee expenses, tax preparation fees or expenses related to investments: Under regular tax rules, you can deduct expenses greater than 2 percent of your adjusted gross income, or AGI. Under AMT, you can't.

-- Some medical expense deductions: Under AMT, you can only deduct expenses if they're more than 10 percent of AGI versus only 7.5 percent under regular tax calculations.

-- Interest on some home-equity loans: If you used the money for something other than buying, building or upgrading a home, you can't deduct the interest under AMT.

-- Incentive stock options: Under the regular tax system, incentive stock options won't cost you anything unless you exercise the options, buy the stock, then sell the stock to realize a gain. Under AMT rules, you'll owe tax on your paper gain even if you never sell the shares.

-- Municipal bond interest income: Income from certain munis is subject to AMT even though they might be tax-free under the regular tax system.

WHAT YOU CAN DO ABOUT IT

If AMT is in your future, there's not much you can do, but there are some steps you can take to minimize the blow.

The first step is to run the numbers or work with your accountant. It may be too late for your 2005 return, but Lassus says it may be possible to group capital gains or various types of deductions in order to avoid AMT for consecutive years.

"If you know you are subject to AMT this year, review options on whether you can pull some deductions or capital gains into the current year to avoid AMT next year," she says.

But for the average New Jerseyan, the only option might be to delay paying property taxes, Lassus says. If you prepay, you'll lose the benefit of the write-off under AMT. Of course, paying property taxes late could mean penalties, so make sure your AMT savings are bigger than any fees you might face.

You could try to defer income to next year, but time is running out and you might set yourself up for AMT eligibility next year. Conversely, if you think next year could be your time for AMT, see if you can take some income before 2005 runs out.

If you've already exercised incentive stock options, you may want to sell some or all of the shares before the end of the year so that the tax treatment is the same for regular and AMT purposes, says Barbara Weltman, an attorney and author of "J.K. Lasser's 1001 Deductions and Tax Breaks 2006" and "J.K. Lasser's Small Business Taxes 2006."

Weltman says you should also check your portfolio for private activity bonds or bond funds. These are bonds issued by a municipality after Aug. 7, 1986, for nonessential purposes such as building a sports stadium. The interest from these bonds is tax-free under the regular tax system, but not under AMT, Weltman says.

The most important move you can make is to be aware of whether or not you could face AMT. If so, spend some time with do-it-yourself tax software or better yet, fork over the cash and hire a tax adviser to see if your personal situation could improve with a little year-end action.