When is a deduction not a deduction?

Deductions but no reductions

Alternative minimum tax is not just for the rich, as many middle-class taxpayers are learning

By Tami Luhby
Staff Writer

February 29, 2004

When is a federal tax cut not a tax cut?

When it forces you into the costly alternative minimum tax (AMT) system.

After Congress, at the urging of the Bush administration, lowered tax rates last spring, many people rejoiced when they received fatter paychecks. What many did not realize is that they might have to give the money back.

Though the AMT was originally designed to make sure the rich paid their fair share, it is hitting a growing number of middle-class taxpayers. The problem is exacerbated this year because of the 2003 tax changes, which lowered the top four tax rates. The less you pay in traditional tax, the more likely you are to fall into AMT, where your tax burden is higher.

"Politically, it sounds good to say you're only paying 25 percent instead of 27 percent, but if you are in AMT, you are not getting the benefit of the full tax relief that was intended," said Frank Degen of Setauket, who heads the National Association of Enrolled Agents, which represents taxpayers before the IRS.

That's why this year tax professionals like Degen are expecting to have to complete a lot more AMT forms and explain to their middle-class clients why they have to pay a tax meant for the wealthy.

Whether you fall into the AMT category is determined by income level, exemptions and deductions (see Calculating the AMT below).

New Yorkers vulnerable

This year's surge in those affected follows a steady increase in AMT returns among the middle class -- a scenario resulting mainly because the alternate system isn't indexed to inflation. New Yorkers are particularly vulnerable to falling into the AMT system because of their high state income taxes and local property taxes and, in the five boroughs, city income tax. These can be deducted from total income on the traditional tax return, but not under the AMT system, so that pushes up their incomes, making them more likely to fall into the alternate tax category.

Recognizing this dilemma, Congress took temporary steps in 2001 to relieve the burden on middle-income taxpayers by raising the amount of the AMT exemption to $40,250 for single people (from $33,750) and to $58,000 for married couples filing jointly (from $45,000). But the exemption amounts revert to pre-2001 levels next year.

So if Congress doesn't act soon, the AMT will squeeze even more people. By 2005, 65 percent of married couples with an adjusted gross income between $75,000 and $100,000 with two or more children will get hit with the AMT, according to the Taxpayer Advocate Service, an independent organization within the Internal Revenue Service helping taxpayers resolve problems with the IRS. Overall in that year, 12.7 million taxpayers will fall into the alternate tax. By 2010, the AMT is projected to affect nearly 32 million taxpayers, most of whom will have adjusted gross incomes under $100,000. Now, about 2.4 million taxpayers are subject to AMT.

To prod Congress to act, President George W. Bush is getting involved. In the administration's fiscal 2005 budget plan the Department of Treasury has proposed renewing the exemption increases, which Treasury officials say is the first time proposals to fix the AMT have been included in the so-called Blue Book revenue plan.

Repeal urged by advocate

Taxpayer Advocate Service chief Nina Olson also has some ideas. Labeling the AMT the top problem facing taxpayers in her 2003 annual report, Olson urged Congress to repeal the AMT. If that can't be done, she suggested establishing a gross income threshold, which would help people determine whether they'll be subject to AMT and will shift the tax to higher-income taxpayers. For instance, she said, Congress could exempt married taxpayers with gross incomes under $150,000 and single ones under $75,000.

Her second proposal involves indexing the AMT exemption to inflation, which tax professionals have advocated for years. If this were done, the number of taxpayers subject to AMT with incomes between $75,000 and $100,000 would drop by 84 percent.

Her final suggestion is to allow taxpayers to deduct their state and local taxes, personal exemptions, as well as standard and miscellaneous itemized deductions, which, under AMT, push many middle- class people into the alternative tax.

The AMT can be a headache for taxpayers to calculate, and it makes tax planning a problem, since strategies like prepaying real estate taxes can backfire if you fall into AMT, Olson said.

"This is just too complicated," she said. "This is more than the average taxpayer should have to bear, and that's who's being pulled into AMT."

Dim future

But it's unlikely Congress will enact any major changes to the AMT this year, especially with elections in November, tax experts said. And it's hard to give up the revenue from AMT. In 2008, the AMT is expected to bring in $85 billion, according to the Tax Policy Center, an analysis group and joint venture of the Urban Institute and Brookings Institution.

So how did this taxpayer nightmare come into being?

The original alternative tax law was enacted in 1969, after Congress discovered that 155 taxpayers with adjusted gross incomes of $200,000 or more paid no tax in 1966. The lawmakers devised a system to prevent the wealthy from taking advantage of certain deductions to unfairly reduce their tax burdens. The current AMT came into being in the mid-1980s.

Ignoring inflation over the years has had a huge effect: When the alternative tax was enacted in 1969, the exemption was $30,000, which equals $150,000 in today's dollars, a fivefold increase. But the current exemption amount is only $58,000 (for married couples) -- about twice the original amount -- and it is set to return to $45,000 in 2005 if Congress doesn't act.

Americans' salaries, however, have risen with the increased cost of living, particularly in expensive regions such as New York. It's not unusual for middle-class families in the metropolitan area to earn in the six figures. But this can throw them into the AMT category.

George Acampora of East Moriches hardly feels wealthy. An air traffic controller in Ronkonkoma married to a part-time controller, he has fallen into AMT for several years.

Until now, it wasn't that big a deal because it only amounted to a few hundred dollars more in taxes. But this year, in part because he moved into a new house with higher property taxes, he has to shell out nearly $5,000 more. That means Acampora won't get the refund he expected to help him add a patio and landscaping to his home.

"I can understand [falling into AMT] if I had rental property and was trying to hide my income," he said. "But because of my state taxes, real estate taxes and my kids, I'm paying $5,000? It's frustrating because there's nothing I can do."

* * *

Calculating the AMT

Here's how AMT works: First you calculate your tax liability under the traditional system and then you complete a 12-line worksheet to see whether you may be subject to AMT.

If you are, you'll have to fill out the two-page Form 6251 to calculate your tax liability under the alternate system. You are taxed at 26 percent on income up to $175,000 over the exemption amount, and at 28 percent for income over that.

Once you know your tax liability under the traditional and alternate systems, you have to pay the higher of the two, said Barry Picker, a certified public accountant in Brooklyn.

A New York family could end up stuck with the AMT return while a family in Florida with the same income would not.

"Look at the real estate taxes on Long Island," said Jeff Spiegel, an accountant with Rosenblatt Radezky Schiff & Tepper in Manhattan. "For the majority of middle-class people on Long Island, that's their biggest deduction. That's getting added back in and throwing them into AMT."

Spiegel is all too familiar with the AMT. The Dix Hills resident got hit with it himself for the first time this year. It will likely cost him a few thousand dollars.

It's very hard to determine in advance if you fall into AMT, and there's almost nothing you can do once you are in it, tax experts say. Often, people turn to professional preparers to handle the forms, which the IRS estimates takes those subject to AMT 63 hours to complete.

If you know you might fall into the AMT category, you could ask your preparer whether you should put off deductions in your high-income years. For instance, you don't want to prepay your property taxes or estimated taxes if you think you may be subject to AMT. Also, you could try to defer bonuses into a year in which you'll be less likely to fall into AMT.

In the end, however, it's up to Washington to fix the problem, tax professionals said.

"Congress can pass tax reductions, but until they do something about the AMT, people aren't going to have real reduction," said Marc Albaum, an accountant in Manhattan