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.”