End of the AMT?

The Alternative Minimum Tax might be nearing its end. Powerful U.S. senators announced their plan to pass a termination of the AMT by the end of 2005. If they are successful, many middle class and upper middle class Americans will breathe easier. But even if the senators are successful, you still must fear getting trapped by the AMT in 2005 and perhaps 2006. Now is the time to plan to avoid the AMT.

The AMT is a separate almost-flat income tax system that was created to reduce the number of very high income people who pay little or no income taxes. A taxpayer computes taxes under the regular tax, and then computes the AMT. The higher of the two taxes is paid.

To compute the AMT, begin with taxable income under the regular tax, then add back various deductions and tax breaks on Form 6251. If you pay the AMT, you do not get the benefit of various tax breaks, such as deductions for state income and property taxes.

There is an exemption amount that is supposed to ensure middle class taxpayers do not pay the AMT. But, except for an adjustment that applies only to 2004 and 2005, it has not been indexed for inflation or income growth. The result is that more and more Americans pay the AMT each year. About 3.8 million taxpayers will pay the AMT in 2005, and more than 20 million in 2006.

The AMT victims are concentrated among those making more than $75,000 annually, especially those with high deductions for state and local taxes, dependents (i.e., big families), and some types of itemized expenses.

To avoid the AMT this year, start planning now. Compute your estimated regular income tax and estimated AMT for the year. If you might have to pay the AMT, consider deferring tax breaks that cannot be used under the AMT. Otherwise, you lose the tax benefits of those deductions that are disallowed or reduced by the AMT.

If you cannot avoid the AMT, turn it into an asset. The maximum tax rate under the AMT is 28%. The maximum regular income tax rate is 35%. If you are trapped by the AMT for only one year, look for ways to bring into 2005 some income that otherwise might not be taxed until 2006.

Some taxpayers are subject to the AMT every year. They should consider reducing or eliminating tax breaks that are not allowed under the AMT.

Let’s take a look at some of the tax breaks that frequently surprise taxpayers by pushing them into the AMT.

One issue that traps some taxpayers is mortgage interest.

There are two types of mortgage debt under the tax code: acquisition indebtedness and home equity indebtedness. Acquisition indebtedness is debt incurred to buy or substantially improve a residence. Refinanced debt is included to the extent is does not exceed the outstanding balance of the outstanding acquisition indebtedness.

Home equity indebtedness is any other mortgage debt. No interest on home equity debt is deductible under the AMT. That comes as quite a surprise to all the taxpayers who have been refinancing their homes or establishing lines of credit to take out equity. Under the AMT, they get no tax break for those interest payments.

No state and local taxes are deductible under the AMT. This includes income, sales, and property taxes. That is why many people in high-tax states get hit by the AMT even if they do not have many deductible expenses. To avoid the AMT, you might be able to defer some of these taxes by paying them in January of 2006 instead of in late 2005.

Personal and dependent exemptions are disallowed under the AMT.

These last two rules show how large families living in high-tax states can be hit by the AMT even when they aren’t taking aggressive actions to reduce taxes.

Interest from most state and local bonds is tax exempt under both the regular income tax and the AMT. But interest from “private activity bonds” is not exempt under the AMT. These are bonds that are used to finance nongovernmental functions, such as stadiums and shopping centers. You need to know before buying a bond if it is financing a private activity. If you invest in municipal bond mutual funds, check the literature to see if they buy private activity bonds.

A number of business and investment deductions are not allowed or are adjusted under the AMT. These provisions affect people with interests in partnerships, S corporations, and limited liability companies. Write offs that might be eliminated or adjusted include depreciation, depletion, gains from asset sales, intangible drilling costs, and long-term contracts. Installment sales and research and experimental costs also are affected. Passive activity losses are curtailed under the AMT.

Charitable contributions are fully deductible under the AMT, except for some contributions of property. Most taxpayers do not have to reduce their charitable giving to avoid the AMT.

Don’t let yourself be surprised by the AMT next spring. Determine now if it might trap you. If it might, consider taking the steps that could avoid the tax.

If your income exceeds $75,000 – especially if it is $200,000 to $500,000 – consider the AMT before making any tax-saving moves. Get a copy of Form 6251 from www.irs.gov. See if you will trigger the AMT for this year before making a final decision.