Publish date:

The AMT Is Coming to Get You

If left unchecked, the dreaded alternative minimum tax will hit 11.3 million taxpayers by 2005.

For legislators and tax professionals, the alternative minimum tax is like a crazy old aunt: getting progressively more difficult to understand, bothering more and more people, and generally faulted with all sorts of untoward behavior.

Aside from some standard tweaking, all three of President Bush's tax laws have left this growing problem unchecked. But it's become clear that the problem is worse than expected -- starting now.

In 2003, some 2.4 million taxpayers will be hit with the AMT, according to the Joint Committee on Taxation. While that's just a fraction of the nation's 130 million total taxpayers, that figure is rising rapidly. In 2004, it will hit an additional half-million people, but in 2005, the AMT's reach will almost quadruple, ensnaring 11.3 million taxpayers if left unchecked.

The alternative minimum tax, or AMT, was created more than 30 years ago to ensure that the super rich paid their fair share of taxes. After all, the very wealthy often don't have traditional earned income, which carries the highest levy. Rather, much of their income is from sources that are taxed at lower rates -- additionally, they're better able to take advantage of various tax shelters and adjustments. The AMT was designed to ensure that everyone's "effective," or average, tax rate is comparable -- well, somewhat comparable. Now, though, because the calculation hasn't been materially adjusted

ever

, the AMT is creeping downward, and instead of simply targeting America's extremely wealthy, it's also hitting those that are merely, er,

very

wealthy.

The AMT is a separate tax calculation that doesn't allow for most of the traditional tax breaks -- in other words, no deduction for mortgage interest or state and local taxes, no tax break on incentive stock options, etc. Instead, these are called "preference items" and, well, are not given any preferential treatment under the AMT calculation. Instead, taxpayers are given one huge income exemption -- $58,000 for married couples and $40,250 for individuals; the remainder is taxed at 26% or 28%.

Today's problem centers on the preference items. Before President Bush's newest tax law, a married couple with $200,000 in taxable income excluding capital gains and dividends could have $26,436 in preference items without triggering the AMT, according to Martin Nissenbaum, the national director of personal income tax planning for Ernst & Young. Now, though, it takes just $21,962 to put them into AMT territory -- almost $5,000 less.

"It's getting to the point where if you own a home in a high tax state like New York you're almost assuredly going to have to worry about the AMT," Nissenbaum says. "And with state and local governments raising rates, that's exacerbating the situation."

TheStreet Recommends

Deductions for high mortgage interest and state and local taxes are two potential AMT triggers. "But that doesn't jibe with the philosophy of the AMT," he says. "I don't think anyone would say that people should pay federal tax on the money used to pay real estate taxes. That's not a tax dodge."

The situation gets worse as taxable income rises. With $300,000 in taxable income, married couples again could claim $26,436 in preference items without triggering the AMT. Now, though, it takes just $16,247 in preference items before they hit AMT territory -- more than $10,000 in lost tax breaks.

The most egregious example are those married couples with more than $500,000 in taxable income who lose almost

half

of their allotted preference items. Instead of being allowed $95,720, they'll now owe AMT with just $48,956 in preference items.

The drop-off in allowable amounts for preference items at the high end is because those income exemptions get phased out at $382,000 for married couples and $273,500 for everyone else.

Sure, the new tax law stipulated that capital gains and dividends that qualify for the low 15% rate will continue to be taxed at that rate, even if the taxpayer otherwise still owes the 28% AMT rate on ordinary income. But that's a bit like shoving all your junk in a closet before company comes -- it seems to make things tidier, but hides the bigger mess.

"If people have most of their income from capital gains or dividends, as many wealthy people do, they're in the AMT forever," Nissenbaum says. "And while that income will still be taxed at the 15% rate, they won't have the benefit of any other deductions."

Also, all this tweaking of the AMT calculation, like everything else in the new law, has an expiration date. That's why the number of people likely to owe AMT shoots up in 2005 -- that's when the minor adjustments expire.

The

debate over how and when to fix the AMT isn't particularly fervid. Sure, Congress knows it needs to be fixed. But it also knows that today's gaping budget deficits may not be the best environment in which to eliminate a major source of revenue. And unfortunately, there's little taxpayers can do if they find themselves repeatedly bumping into the AMT.

"It needs reform more than repeal," Nissenbaum says. "Congress needs to nail down what they perceive are abusive means of avoiding tax. They should not allow this to trap people."