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Money, September 2003

THE TAX OF UNINTENDED CONSEQUENCES

The AMT was supposed to ensure that the wealthiest Americans couldn’t shelter all their income from taxes. So why is it that one-third of U.S. taxpayers, most likely including you, may well face the AMT in 2010? And what can you do about it?

If you’re expecting to enjoy all the benefits of the latest round of federal tax cuts, you may need to think again. For many of us, much of what the government gave with the regular income tax breaks, it will soon take away with the alternative minimum tax, or AMT. Without a major fix, which could cost the Treasury upwards of $1 trillion, a tax system designed for the richest families will soon hit tens of millions of us.

Back in 1969, Congress came up with the idea of an alternative tax as a way to prevent the very wealthy from using tax loopholes to avoid paying income tax. Not a bad idea, in theory. In practice, however, the AMT has become the ticking time bomb of the tax code. The AMT now hits 2 million taxpayers and threatens 31 million more, roughly one in three, by 2010, according to forecasts from the Urban-Brookings Tax Policy Center. Among them will be millions of middle-income and upper-middle-income taxpayers: 37% of households with incomes between $50,000 and $75,000; 73% with incomes between $75,000 and $100,000; and a whopping 92% who earn between $100,000 and $200,000.

Landing in the AMT has one unavoidable, unwelcome consequence: a higher tax bill. “The reality of the AMT is that it is a hidden rate increase,” says Michael Radford, national managing partner at Deloitte & Touche Investment Advisors. Worse, you’re likely to pay more not because you’ve been signing on to some dodgy oil and gas partnership but because the AMT treats your children and your state taxes as if they were tax shelters. It is, in the words of Bernard Kent of PricewaterhouseCoopers’ financial planning practice, “a very unfair and arbitrary tax.”

Not only will you pay more, but you’ll tear your hair out doing it. Everything (and we do mean everything) is different in the AMT than the regular tax system — your taxable income, your deductions, your exemptions, even the way you calculate depreciation. Figuring out your AMT is so complicated that it may take an extra 12 hours to keep records and complete the forms, according to the Internal Revenue Service’s own Taxpayer Advocate. And forget about filling out those forms by hand; you need tax software — and, if your financial life is complicated, you need professional help.

Various bills have been introduced to reform the AMT, but so far the fixes have been temporary. The cost of a real solution would be astronomical, and with the federal government now facing a $455 billion budget deficit there seems little chance of that happening anytime soon. “This is a problem that should have been dealt with when we had the money, and it wasn’t,” says Leonard Burman, a senior fellow at the Urban Institute and co-director of the Tax Policy Center.

If you’re worried, you can, and should, write your congressman. But while you’re waiting for the AMT to be fixed, it’s important to learn how it works and whether to make changes in your own tax planning. Read on for our guide to the bewildering universe of the AMT.

THE ABCs OF THE AMT
The AMT is a tax system parallel to the regular income tax. You fill out your regular 1040 and Form 6251 (Alternative Minimum Tax, Individuals) and compare the taxes due. Whichever amount is higher is the one that you pay. (Technically, your AMT is the amount you pay above your regular income tax.) Under the AMT, your taxable income will be larger because you cannot take deductions for state and local taxes, property taxes, unreimbursed business expenses and the like. Only a handful of deductions, including those for home mortgage interest and charitable contributions, are allowed. The AMT rates, 26% on income of up to $175,000 (for married couples filing jointly and singles; $87,500 for married filing separately) and 28% on income above that amount, are lower than the highest marginal tax rate in the regular tax system. But because of the way the alternate system operates, the effective tax rate under the AMT will usually be higher.

Why does this tax that was originally targeted at a few very wealthy households now hit millions? There are two main reasons. First, it was never indexed for inflation. (The regular income tax was indexed in 1981.) Second, a series of tax cuts have slashed marginal rates for the regular tax but left AMT rates untouched. “The 2001 law made the AMT roughly twice as bad as it would have been otherwise, and the 2003 law sped up things that were a problem in 2001,” says the Urban Institute’s Burman. The combination of lower federal tax rates and higher itemized deductions (for rising state taxes, property taxes and so on) amounts to “the perfect storm for AMT,” says Martin Nissenbaum, national director of personal tax planning at Ernst & Young.

The risk factors
While no simple formula determines whether you’ll be hit, certain moves — exercising incentive stock options is one — will almost inevitably land you in the AMT. But other triggers are more perverse, and less controllable.

If you live in a high-tax state, such as New York or California, you are more likely to pay AMT than if you live in a low- or no-tax state like Texas or Florida, since you can’t deduct state and local levies. What’s more, 11 states, again including New York and California, levy their own alternative taxes.

The more children you have, the greater your chances of being subject to the AMT, which has no exemptions for dependents. In one much-publicized court case, a Kansas family with 10 kids was required to pay $1,058 in AMT largely because of the loss of those exemptions.

Ironically, it’s also more likely that you’ll find yourself in AMT territory if you are upper middle class than if you are really rich. That’s because the spread between the marginal tax rates under the regular tax system and the AMT rates is wider for the rich (35% vs. 28%) than for the upper middle class (28% vs. 26%).

Bottom line: You’re at risk of paying the AMT within the next few years if you’re married with kids, take some capital gains and live in a high-tax state. In fact, according to the Tax Policy Center’s estimates, 64% of married couples with two or more children will face the AMT by 2010, and almost 6 million households will join the ranks of AMT payers solely because they have kids.

The AMT exemption
The AMT system does now allow the regular income tax’s personal exemption, but it has its own exemption: a flat dollar amount that can be lopped off your taxable income. The most recent tax cut included an AMT patch boosting the exemption to $58,000 for married couples filing jointly and $40,250 for singles.

But there’s a catch. In fact, there are two catches: the sunset and the phaseout. Sunset is Washington-speak for a provision of the tax code that will expire at a certain date unless it is extended by Congress. Without congressional action, the AMT exemption will plummet to $45,000 for marrieds filing jointly and $33,750 for singles at the end of 2004 (and from $29,000 to $22,500 for married filing separately) — right after the next presidential election. That sunset alone will push millions of taxpayers into the AMT in 2005.

The phaseout sets income limits for the full exemption — $150,000 for marrieds and $112,500 for singles — after which it reduces the exemption at a rate of 25 cents on the dollar until the exemption disappears completely at $382,000 for marrieds and $273,500 for singles. This phaseout can raise the effective tax rate to 35%, according to the Tax Policy Center.

Dividends and capital gains
This one is tricky. The new 15% rate on qualified dividends and long-term capital gains does apply to the AMT — but with a catch. If your income is in the phaseout range, each additional $1 in investment gains will add $1.25 to the income on which you’ll be taxed, pushing the effective tax rate on that gain higher than 15%.

Consider an example: Let’s say you book a $1,000 long-term capital gain and have no offsetting losses; your capital-gains tax is $150. But if you’re an AMT payer in the exemption phaseout range, you lose $250 of your exemption. If you’re in the 28% AMT tax bracket, that means an extra $70 in tax, putting your total tax on that capital gain at $220, or 22%. And if you live in a state that taxes capital gains, your effective rate would be higher still. “In AMT under the phaseout period, you could end up with an effective rate over 30%,” says Richard Hervey, a tax partner at the Dechert law firm in New York City.

WHAT YOU CAN DO: TAX PLANNING STRATEGIES
While you have less flexibility in the AMT than under the regular tax system, there may be steps you can take to reduce your exposure and perhaps your tax. But you must do the numbers early. “People have to realize what items will trigger AMT,” says Jere Doyle, a senior director in Mellon’s private wealth management group. “You cannot come to the end of the year and have your tax preparer wave a magic wand and make it go away.”

To see how close you are to becoming an AMT payer, check out H&R Block’s online AMT calculator at hrblock.com/taxes/tools/amt/index.html. Do this now, and if you’re within, say $1,000 of the AMT, run the numbers in more detail before the end of the year. If you have a tax adviser start discussions with that person early. If you have incentive stock options, investment real estate, large unreimbursed business expenses or other major complications and don’t have an experienced tax adviser, get one now. Otherwise, just as soon as the tax software for 2003 is available, use it to get a clearer picture of where you stand. (The IRS will not send you the AMT form automatically, and, even if it did, you shouldn’t attempt to fill it out by hand. Although it may look simple, it may require redoing a whole host of other forms.)

None of this is simple. Calculating your AMT obligation is “a series of what-if scenarios,” says Gayllis Ward, head of the tax department at Fiduciary Trust. “In some case, people are stuck there, and that’s the tax regime they pay under. Other times, you look and say, ’You could have a better result if you did this.’”

If you’re not “stuck” in the AMT, say you realized a large capital gain from the sale of a property that pushed you into the AMT for a year or two, a tax adviser may suggest that you arbitrage the two tax codes. Ideally, you would push you deductions into a year when you’ll be covered by the regular tax system, and move income into an AMT year if the AMT rate is lower than your marginal tax rate. If you’re in the 35% tax bracket, $1,000 in additional income is worth $70 more to you in an AMT year, since it will be taxed at 28%. (One caveat: If adding income to your AMT year makes you lose part or all of your exemption, you don’t want to do it.)

But whether you’re in the AMT only one time or permanently you need to think in a new way about the tax consequences of some very common financial moves, moves that would normally have significant tax benefits. Watch out for these two.

Home-equity loans: Redo the math
Unless you use the proceeds to buy a home or substantially improve your home, the interest on home-equity loans and second mortgages is not deductible under the AMT. You may still want to take the loan, especially with interest rates at historic loans, but recognize that the loan may cost more than you expect.

Muni bonds: Are they really tax-free?
Under the AMT, true munis remain tax-exempt, but private-activity bonds, those issued by a state or locality to fund private activities, such as building a sports stadium, do not. For AMT purposes, you must add back to your income all distributions from private-activity bonds.

If you own a muni bond fund, you may have private-activity bonds in your portfolio and not even be aware of it. One tip-off: A muni fund is allowed to call itself “tax-exempt” or“tax- free” only if its maximum investment in private-activity bonds is capped at 20%. Read the prospectus for more details. Your year-end statement will include a breakdown for AMT purposes.

Although the yields of private-activity bonds are typically higher than those of regular munis, for most AMT payers the after-tax yield will be lower. So stick with true tax-exempt munis, which get the tax break under both systems.

WHERE YOU’LL NEED HELP: TIMING TRAPS
Dealing with the AMT will be a challenge for most middle-income and upper-middle-income taxpayers. But if you invest in real estate, even if it’s just owning and renting out the house next door, or you exercise incentive stock options, the AMT can cause problems that will dog you for years.

Real estate investments
The villain here: depreciation rules. Under the AMT, you may need to spread the depreciation for your investment real estate and other assets over a longer period of time than you would under the regular income tax. The result: You’ll write off a smaller amount each year. As that depreciation number flows through your tax return, you’ll report different passive losses, which are suspended until the sale of the property. To avoid a tax-computation nightmare when you sell, you should track both your depreciation and your passive losses under the two systems from the day that you make the investment. That’s because when you sell, your cost basis may be different for the AMT than for the regular tax system, and you won’t know which one applies to you until you fill out both sets of forms for the tax year of the sale. Your tax filings could easily span 80 pages. Get professional advice.

Incentive stock options
These options promise a tax break over their more common cousins, nonqualified stock options, and a peck of trouble if you handle them wrong. Under the regular tax system, you owe no tax when you exercise ISOs, and as long as you hold the shares for a year, your gain is taxed at 15% when you sell. The AMT, however, requires that you report an adjustment for your paper gain when you exercise; that adjustment will almost inevitably throw you into the AMT. If the stock tanks before you sell, you could owe thousands, or even tens of thousands, in AMT on gains you never got.

“The people who are freaking out the most are those who have paid enormous sums of money to the government on profits they never saw, or those who could not afford to pay the government and the IRS is taking out liens on their homes,” says Andy Mattson, an accountant at Mohler Nixon & Williams in Silicon Valley.

Our advice: If you have ISOs, exercise only small blocks of shares at any one time to minimize your chances of owing AMT, or, when you exercise, sell enough shares to cover the tax. That way you will never owe the IRS money that you do not have. If, however, you exercise a large chunk of ISOs all at once for a large paper gain and the stock promptly tanks, sell the shares during that tax year. That’s called a “disqualifying disposition” and essentially converts your ISOs to nonqualified stock options for tax purposes, which means you don’t have to report an adjustment on the exercise under AMT.

WHAT YOU CAN DO: TAX-FILING TACTICS
Once it’s time to file your taxes, all you can do is make the best of a bad situation. First, be sure to calculate your potential liability; if the IRS determines that you owe AMT and did not pay it, you’ll be liable for interest and penalties. Then do the following:

Test the itemized deduction
One of the many oddities of the AMT is that taking the standard deduction may lower your regular tax burden but raise your AMT. The reason: In the AMT, you can’t use the standard deduction ($9,500 for marrieds, $4,750 for singles), but you can deduct, say, $1,000 of charitable contributions that you wouldn’t be allowed with the standard deduction. Worse, the rules say that once you’ve claimed the standard deduction to calculate your regular tax bill, you must also use it for the AMT, even if itemizing would save you money. So calculate your potential tax four times — with and without itemizing for both the 1040 and the 6251— before you file.

Claim the AMT credit if you’re eligible
There is one credit specific to the AMT, but it is very limited. You can’t claim the credit because you lose exemptions for kids and deductions for state and local taxes, the most common AMT triggers. You are eligible only if you lost timing benefits that you would have enjoyed under the regular tax. That’s the case with ISOs. To claim the credit, you file Form 8801 (Credit for Prior Year Minimum Tax — Individuals, Estates and Trusts) beginning the first year you are eligible.

But this being the AMT, there are further complications. First, you can claim the credit only in a year when you’re not subject to the AMT. So if you’re permanently in AMT territory, you may be stuck with a credit that you can’t use. Second, the amount of the credit you claim in any year is limited to the difference between your regular tax and the tax calculated under AMT rules.

Let’s say you have an $8,000 credit available from 2001; for 2002 you owed $37,000 under the regular tax rules and $32,000 under AMT. You would be able to use $5,000 of your credit when you file your 2002 return. The remaining $3,000 credit gets carried forward and, again, can be used only in a year in which you pay tax under the regular system. If you’ve got a very large AMT credit — say, $100,000 or more — it could take years, even decades, to use it up. And rules are rules: There’s not a lot you can do to access it faster.

Good luck.

SIDEBAR: TRAPPED BY ISOs
Stuart Bell knows what tax purgatory looks like: He owes well over $200,000 in AMT (including interest and penalties) for phantom gains on incentive stock options, and he doesn’t have the money to pay. Bell, 37, his wife Leslie and their children, Christina and Andrew, ages two and five, live in Austin. During the boom, he received ISOs from his employer, WebMethods, a high-flying dotcom. In September 2000, with the stock at $101.50, he exercised 6,707 options at $2.88 and held on to the shares. Under regular tax rules, he would owe no tax until he sold the stock, and if he held it a year, he’d pay the lower long-term capital gains rate. But that $99-a-share paper gain subjected him to the AMT, to the tune of $189,754. The stock market tanked, there were restrictions on when he could sell, and by the time he’d unloaded those shares, they were worth an average of $13.36 apiece. Now Bell, who made $170,000 in salary and bonuses at the peak but was recently laid off, is deep in negotiations with the Internal Revenue Service over that tax liability through a program called Offers-in-Compromise. The IRS has rejected his offer, despite his having turned over $60,000 in what he says was a good-faith effort to repay the tax debt, because, he says, his is not considered a hardship case. Now, Bell says, he’s looking into filing for bankruptcy in hopes of gaining some negotiating power with the IRS. “I am just scared to death,” Bell says. “I can’t pay back a quarter of a million dollars. It is unfair and unrealistic.”

SIDEBAR: HEADED FOR THE AMT
Who’s at greatest risk of paying AMT? Folks like Ron and Joelle Mertzel of Tarzana, Calif. Ron, 33, works for a real estate developer; Joelle, 30, works part time from home as a publicist. Their first child, Aaron, is four months old. They own their house, sock away money in their 401(k)s and dabble in real estate. Last year they earned $170,000; this year they figure they’ll make $210,000 (including a gain on a real estate investment). Ron has always done their taxes himself and never given the AMT any thought. “There are so many random categories where you just think, ’Oh, this can’t apply to me,’” he says. “I just put a line through it and didn’t even look at it.” So far, he’s been right. But according to an analysis of their tax situation prepared for MONEY by Phillip Schwindt, a senior research analyst in the tax compliance unit of CCH, the combination of federal tax cuts and their higher state taxes, plus their baby, could push them into AMT this year. While the latest tax package would cut their regular tax liability by $3,971, according to CCH’s analysis, the AMT would take back $585, or some 15% of those savings. Their projected AMT: $859. And in 2005, if the current AMT exemption expires and all else remains the same, they’ll owe $4,239 in AMT. Ouch. Bio photo