The ABCs of the AMT

By 2010, about one out of three households will be ensnared in the alternative tax system.
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Fall in love with the AMT.

That's right. Get personal with the alternative minimum tax.

You might as well, because it likely could become a part of your household in the near future.

The Joint Committee on Taxation estimates that 3.6 million taxpayers will be hit with the AMT this tax season. And if the rules don't change for 2006, 19 million will be singing the AMT blues next year. What's worse, roughly 30 million tax households will be paying AMT by 2010. That's one in every three tax returns.

Currently, folks who have household earnings between $100,000 and $200,000; own a house in a state with high state taxes; and who have dependents are the biggest targets. And if something substantial doesn't happen to abolish this system, by 2010, people making $75,000 to $100,000 will be hit as well, says Rande Spiegelman, vice president, financial planning, for the Schwab Center for Investment Research.

The reason for this complete inequity: The AMT is not indexed for inflation. Regular tax rates have been adjusted over the years, but the AMT has remained unchanged even though personal income has grown.

And to make matters worse, the AMT has become the equivalent of your local Girl Scout troopselling those fabulous Thin Mints -- a big revenue raiser. So the folks in Congress don't see any incentive to give it up.

The only upside is that once your income gets above $400,000, you probably won't have to worry about the AMT anymore. (Of course, your tax bill will be quite juicy at that point, anyway.)

AMT: A Mountain of Technicalities

There are two parallel income tax systems in the U.S.: the regular income tax system and the alternative minimum tax system. The AMT system was created in 1969 to prevent the rich from wiping out their tax bill with credits and deductions. The idea was that everyone had to pay at least some tax.

As a result, you have to calculate your tax bill under both systems and pay whichever bill is higher. For those of you who aren't in AMT territory yet, you probably had no idea that your tax return was calculated two different ways. When you plug your information into a tax preparation program like TurboTax, it calculates both tax bills without you even knowing.

But to better understand this ridiculous system, let's walk through the process.

First, calculate your regular tax bill. You know the drill here. You take all your income, then subtract your dependent exemptions, your itemized deductions, credits for child care, etc.

The final number is your taxable income, and your tax rate is applied to that amount to determine how much you owe Uncle Sam.

Now calculate your bill under the AMT system, which has an entirely different set of rules. Start again with your income. You don't have much subtracting to do because you're not allowed to deduct things like your dependency exemptions. And if you took the standard deduction under the ordinary system, you can't deduct that here either. (Hmmm. If this system was created to tax the rich, why is the standard deduction disallowed? How many rich people do you know who take the standard deduction?)

If you itemized your deductions, you can no longer deduct your state and local taxes paid and property taxes. You can't deduct the interest on that home-equity loan you took out to pay for college. And those miscellaneous itemized deductions -- forget those, too. Among the deductions that stay in place under the AMT system are charitable contributions, mortgage interest and certain medical costs.

But with so many deductions taken away, odds are good your taxable income under the AMT rules is higher than it was under the regular rules. Granted, the highest AMT rate hits only 28%, while under the regular system your tax rate could be as high as 35%. But the taxable income applied to that 28% is bigger under the AMT system, so the lower rate doesn't really matter.

Ugh. Now what?

Get Some Protection

While there are no cut-and-dried rules that determine who the next AMT victim will be, there are some things that should put you on guard.

If you took out a home-equity loan to pay for college, your kid's wedding or that long-awaited trip around the world, you can't deduct that interest under the AMT system. Loans used to make improvements on your home are just fine, but when the proceeds go to other miscellaneous life events, you're out of luck.

Generating long-term capital gains can be a blessing and a curse, especially if you're cashing in a big chunk of shares. That additional income can throw you into AMT land pretty quickly, so consider the timing of your sales. And keep in mind that the state income tax you pay on that capital gain is not deductible under the AMT.

If you have incentive stock options, don't do a thing until you get professional help. Exercising these things can catapult your tax bill into the thousands if not timed properly. Just ask anyone who got caught up during the tech bubble.

If you own a limited partnership or rental real estate, again, get professional help. "If you're involved in passive investment activities like these, especially where asset depreciation is involved, the rules become increasingly complex," says Spiegelman.

Watch out for private-activity municipal bond interest. That interest is tax-free under the ordinary tax system, but not under the AMT.

Prepare Now for Next Year

So are you in or out this year? Either way, it's too late to really do anything except be ticked off and call your congressman.

But you can start to prepare for next year. Check out H&R Block's

AMT estimator so you can get an idea of what 2006 will look like. Then find a professional to help you navigate through this maze of esoteric rules.

Sure, people will tell you to consider tactics, like pushing off state and local tax payments into the following year or trying to bunch your miscellaneous itemized deductions into a year that will no longer carry the AMT moniker. But while those strategies may help, they could also make things worse. So rely on a pro.

And then stand up for yourself. "My biggest advice is to be civically minded. Call your congressman and tell him this should be changed," says Jackie Perlman, a senior tax research analyst at H&R Block.

Tracy Byrnes is an award-winning writer specializing in tax and accounting issues. As a freelancer, she has written columns for wsj.com and the New York Post and her work has appeared in SmartMoney and on CBS MarketWatch. Prior to freelancing, she spent four years as a senior writer for TheStreet.com. Before that, she was an accountant with Ernst & Young. She has a B.A. in English and economics from Lehigh University and an M.B.A. in accounting from Rutgers University. Byrnes appreciates your feedback;

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