| You may
have heard people who talk about money or politics for a
living mention something about the Alternative Minimum
Tax, or AMT, as it is often called. Mention of the AMT
has become more frequent of late because millions more
taxpayers will be forced to calculate and pay this tax
in the next few years. Dubbed "the stealth tax," the AMT
has been blindsiding many "ordinary" taxpayers who count
on taking what have become "ordinary" deductions. The
AMT has been made even more dangerous by the labyrinth
of rules for calculating the tax, which are complicated
enough to give seasoned tax professionals fits. There
are two questions that taxpayers want answered when it
comes to the AMT: "What is it?" and "What can I do to
avoid it?"
What Is The AMT?
The AMT is a separate
income tax calculation that was originally designed to
ensure that wealthy taxpayers who had lots of deductible
expenses paid a fair amount of income tax. The AMT
replaces the regular tax brackets with just two tax
rates and disallows most regular deductions in favor of
a standard AMT deduction. The AMT gets rid of deductions
for dependents, state and local taxes, some mortgage
interest, and miscellaneous items, among others.
The reason why the AMT
concerns so many people, when it was only aimed at the
very wealthy, is that the AMT is not adjusted for
inflation, as is the standard income tax. In the past
few years, Congress has temporarily increased the amount
of the standard deduction, which has kept a few more
taxpayers from having to pay the tax. However, the "AMT
patch" is set to expire in 2007, and a permanent
solution would reduce future tax revenues by billions.
While it is reasonable to assume that Congress will get
around to fixing the problem before it becomes a
campaign liability, this may not be soon enough for you,
so it's up to you to know whether your circumstances put
you at risk of having to pay AMT.
How Do I Avoid It?
AMT is triggered by a
combination of income and deductions. The lower your
gross income is, the less likely that you'll have to
worry about AMT. Still, it's not much help to suggest
that you avoid taxes by not working (or by working for
free), so the deductions are what matters most here. For
the most part, AMT liability is caused by itemized
deductions, although in some cases, families with many
dependency exemptions also get hit. If you don't itemize
your deductions, it is almost a certainty that you won't
have to pay AMT.
If you have more than
eight dependents, you are more likely to pay AMT
regardless of other deductions. There is not much to say
about this fact except that if any of your children are
full-time college students under age 24 who also work,
it is worthwhile to determine whether to claim them as
dependents or not. If you are in an AMT situation,
you'll lose the dependency exemptions anyway.
The big problems are
with itemized deductions, though. Aside from the lack of
inflation adjustments creating AMT bracket creep, the
two most significant reasons why taxpayers get pushed
into AMT situations are the deductions for mortgage
interest payments and state and local property taxes.
Increasing home prices are part of the reason why
taxpayers claim larger deductions for each, since they
affect both the amount needed for financing and the
assessment base for property taxes. Deductions for state
and local taxes are completely disallowed under AMT, but
there are only a few items to look out for on the
margins.
Watch mortgage
interest. The single largest itemized deduction
on most taxpayers' returns is the one for mortgage
interest expense. AMT does not disallow most of the
deduction for mortgage interest, but the rules are
different. What AMT does not allow are deductions for
interest on loans not used to buy, build or
substantially improve a first or second home. That means
that interest on home equity lines of credit (HELOCs)
may not be deductible under the AMT.
With interest rates as
low as they have been recently, many people have used
the equity in their homes to pay down credit card
balances and other debts. Encroaching AMT liability
means that if you have a balance on a HELOC that was not
used to finance capital improvements to your home, then
you will want to reduce this balance before the interest
charges become non-deductible. You may have a few years
to do this, so don't do anything drastic like borrowing
the money from another source or tapping retirement
savings, as those methods have no tax advantages and may
incur other problems.
Avoid
miscellaneous deductions. The other major tax
preference item that is disallowed is the deduction for
miscellaneous items such as unreimbursed employee
business expenses and other costs incurred in the
production of income, such as litigation costs for
plaintiffs in lawsuits. Knowing this, you may be in a
position to negotiate a better solution with your
employer or attorney. Most plaintiffs' attorneys don't
know much about tax law, so you may want to have your
tax advisor meet with your attorney if you are in a
position to obtain a significant settlement.
Lower state and
local income taxes. If you are in a high income
tax state, the AMT also is more likely to affect you.
That's because state income taxes are itemized
deductions for regular tax purposes, but are completely
disallowed for computation of the AMT. Short of moving,
however, your efforts can be directed toward reducing
your state income taxes through available deductions and
credits on the state or local level. Because of the AMT,
these deductions and credits take on added significance
to your combined state and federal tax bottom line.
None of these solutions
is perfect, and using them may not completely eliminate
AMT liability. You are better off knowing about them,
however, and could save money in the long run by looking
out for AMT pitfalls. Please contact this office if you
want to know more about taking the right steps to
protect your tax return from the AMT "stealth tax." |
