Understanding the Alternative Minimum Tax (AMT)

If you aren’t already familiar with the alternative minimum tax (AMT), there’s a good chance that your family soon will be. This is because its key figures aren’t indexed for inflation. As a result, the AMT continues to snare more middle-income Americans every year. Additionally, because temporary legislative band-aids expired at the end of 2006, our nation’s economic stage is set for a dramatic rise in the number of individuals who are affected.

What is the AMT?
The AMT is essentially a separate federal income tax system with its own tax rates and set of rules which governs the recognition and timing of income and expenses. If you’re subject to the AMT, you have to calculate your taxes twice–once under the regular tax system and again under the AMT system. If your income tax liability under the AMT is greater than your liability under the regular tax system, the difference is reported as an additional tax on your federal income tax return.

Are You Subject to the AMT?
Part of the problem with the AMT is that, without doing some calculations, there’s no easy way to determine whether you’re subject to the tax. Key AMT “triggers” include the number of personal exemptions you claim, your miscellaneous itemized deductions, and your state and local tax deductions. So, for example, if you have a large family and live in a high-tax state, there’s a good possibility you might have to contend with the AMT. IRS Form 1040 instructions include a worksheet that may help you determine whether you’re subject to the AMT (an electronic version of this worksheet is also available on the IRS website), but you might need to complete IRS Form 6251 to know for sure.

AMT Adjustments
Differences between the regular and AMT calculations include:

• The standard deduction and deductions for personal exemptions are not allowed for purposes of calculating the AMT.
• Under the AMT calculation, no deduction is allowed for state and local taxes paid, or for certain miscellaneous itemized deductions.
• Under the AMT calculation, any deduction for medical expenses may also be reduced, and qualifying residence interest (e.g., mortgage or home equity loan interest) can only be deducted to the extent the loan proceeds are used to purchase, construct, or improve a principal residence.
• Special AMT treatment applies to the exercise of incentive stock options (ISOs) and to the treatment of certain depreciation deductions.

AMT Exemption Amounts
While the AMT takes away personal exemptions and a number of deductions, it substitutes a specific AMT exemption amount. The AMT exemption amount that you’re entitled to depends on your filing status and income (AMT exemption amounts are phased out for individuals with higher incomes). A patchwork of legislation since 2001 has, along with other AMT provisions, pumped up AMT exemption amounts to stave off a spike in the number of taxpayers caught in the AMT “net.” The bad news, though, is that the last legislative patch expired at the end of 2006. Unless Congress passes new legislation, 2007 AMT exemption amounts return to pre-2001 levels, and the number of taxpayers subject to AMT is expected to skyrocket.

Legislative Outlook
Several bills have been introduced in the current Congress relating to the AMT. Proposals range from another one-year patch to full repeal. The problem with repealing the AMT is that it would leave a significant revenue gap (the Joint Committee on Taxation projects that the AMT will account for almost $25 billion in revenue for the 2006 tax year). That means we’re more likely to see another short-term fix than we are to see substantive reform.

Help is Available
Owing AMT can be an unpleasant surprise. It also turns a number of traditional tax planning strategies (e.g., accelerating deductions) on their heads , so it’s a good idea to factor in the AMT before the end of the year, while there’s still time to plan. If you think you might be subject to the AMT, it’s worth sitting down to discuss your situation with a qualified tax professional. Until our federal government decides to substantially reform the current system, more American families will continue to carry this additional tax burden.