AMT, the Tax We Love to Hate

AMT tax patch spares millions, but big families and residents of high-tax states are still vulnerable to the stealth tax.

By Mary Beth Franklin, Senior Editor, Kiplinger's Personal Finance

More than 20 million middle-class tax payers have been spared—once again—from being subject to the alternative minimum tax. Created back in 1969, in an era when tax rates went as high as 91%, the AMT was designed to make sure that the very wealthy couldn’t use loopholes to escape all their tax obligations.

But because the AMT was never indexed for inflation, it gradually morphed from a “class tax” into a “mass tax,” claiming additional middle-class victims each year. In response, Congress pushes regularly pushes through AMT “patches” to increase the income level at which the stealth tax kicks in. As part of the major tax law approved in late December, Congress agreed to patch the AMT for both 2010 and 2011.

But if you paid the AMT last year and your financial situation remains about the same, you’re likely to feel the sting again when you file your 2010 tax return. For 2010, the exemption amounts were increased to $47,250 for single taxpayers and heads of household, and $72,450 for married couples filing joint returns.

Double trouble

The AMT is a parallel tax system. Every taxpayer is responsible for paying the higher of the regular tax or the minimum tax. Essentially, it means you have to do your taxes twice. First, you have to figure your regular federal tax and then calculate the AMT, which disallows many common deductions and credits. If the minimum tax is higher, the difference between the two tax rates is added to your Form 1040 as an additional alternative minimum tax.

Although the AMT rates of 26% and 28% are lower than the upper income tax rates of 33% and 35%, you pay taxes on more of your income, raising your overall tax bill. Use IRS Form 6251 to calculate the difference between the two tax rates. If you use tax-preparation software, it will automatically calculate your AMT liability. A professional tax preparer should do the same. But if you’re still doing your taxes the old-fashioned way, get ready to tear your hair out if you have to tackle Form 6251 on your own. You can test drive the IRS’s AMT Assistant tool (www.irs.gov) to see whether you’re vulnerable, but even that is a lot of work.

Likely victims

No single item alone may trigger the AMT. However, you are more likely to be snagged by the AMT if you have income of $100,000 or more; you claim a lot of itemized deductions for expenses such as state and local taxes; or you have a larger number of personal exemptions for you, your spouse and your dependents. Consequently, taxpayers with large families or those who live in high-tax states, such as California and New York, are more likely to find themselves subject to the stealth tax.

Exercising incentive stock options is another common AMT trigger, requiring you to prepay the tax on your paper profits. If the stock later plunges in value before you can sell it, that’s just too bad. The AMT has to be paid, although you can recoup offsetting tax credits in future years.

Although you can still deduct medical expenses, home-mortgage interest and investment interest under the AMT, different rules apply. For example, under the AMT, you can deduct only those out-of-pocket medical expenses that exceed 10% of your adjusted gross income compared with a 7.5% threshold under regular tax rules. Although most Democrats and Republicans agree they would like to abolish the AMT, the reality is the stealth tax rakes in a lot of revenue—something that is in great demand during times of large federal budget deficits. Every time Congress approves a patch to raise the exemption level and protect the middle class, it costs a lot of money. Just extending the AMT patch for 2011 and 2011 is expected to cost the federal government $136 billion in lost revenue.