Don't get bitten by this Awfully Mean Tax

By Jeff Schnepper

Just when you thought you've done your tax planning and you’re ready to start doing your return, I urge you -- no, beg you -- to take a hard look at the Alternative Minimum Tax.

It may cost you more on your 2007 tax return. It could cost you on your 2008 return as a growing number of us get sucked into it just for buying a new home or having another child.

The AMT (which I think should be renamed the Awfully Mean Tax) is an alternative tax computation that disallows your personal exemptions and many of your deductions. After allowing a given AMT exemption, the balance is subject to a flat 26% or 28% rate. You use Form 6251 (.pdf download) to do the computation.

The AMT is tricky and can cause you all sorts of trouble.

In recent years, Congress voted to reduce -- but not eliminate -- the potential of having to deal with the AMT. The AMT exemption for 2006 is $66,250 for joint returns ($33,125 for married couples filing separately) and $44,350 on single returns. That is an increase over 2006 and the result of furious lobbying that went all the way to Christmas. That means if your taxable income (plus some adjustments) is less than these amounts, you're not subject to the tax.

It's 2008 that you should start to think about, because the tax extender bill that was finally passed did not include extending these higher exemptions.

So, the exemption for joint returns will drop to $45,000 and drop to $35,750 for single returns. Obviously, Congress will be under pressure to extend the larger exemption amounts into 2008 and later.

Despite the increased exemptions, some 19 million taxpayers will be subject to the AMT when they prepare their 2007 returns. And more than 35 million taxpayers are projected to fall victim to this add-on tax by 2010. Whether it's going to hit you depends on your particular tax and financial position, and on where you live.

So, here are some of the pitfalls to watch for and tips on how to organize your finances to minimize your odds of being slammed with the AMT, and what to do if this tax tsunami washes away your refund.

Who gets hit

You may get hit if:

• You live in one of those states without a state income tax. Sorry, but it may be time to come down to earth and wipe that smile off your face. In the name of tax equity and fairness, Congress has resurrected the deduction for sales taxes. You can now deduct the higher of your state and local income taxes, or the sales tax you paid during the year. But, these taxes you pay and deduct are included in what the tax pros call AMT preferences. That means they're not allowed as deductions for the computation of the AMT.

• You live in a state with high state and local taxes, including income, property, personal property and, yes, sales taxes. About half the people paying the alternative minimum tax in 2003 lived in California, Connecticut, the District of Columbia or New York. High property taxes -- they can be $10,000 or more in parts of New York and New Jersey -- can easily trigger the AMT.

• You have a large family. I have a client with eight children who's hit by the AMT every year. That's because he loses 10 personal exemptions in the AMT calculation. In 2004, that was like increasing his taxable income by $31,000.

• You claim big miscellaneous deductions. Are you an employee with substantial unreimbursed employee business expenses? Do you have huge investment or tax-preparation deductions? How about union dues or job-related continuing education? All of your miscellaneous itemized deductions are wiped out in the AMT computation. This increases your exposure to the AMT slam.

• You have extraordinary medical expenses. For the AMT, they have to be reduced by 10% of your adjusted gross income rather than the 7.5% allowed under the normal tax calculation.

• You exercise incentive stock options. The excess of the fair-market value received through the exercise of the option over the exercise price is a preference item. If you want to understand the concept of tax hell, exercise the options and then watch the value of your stock go down. In the first years of this decade, as stocks swooned, many taxpayers were slammed by the AMT while the value of their stock investments disappeared. You get taxed on a paper gain while your real net worth goes down.

What to do

If you're going to be hit with the AMT, your normal tax-planning rules are reversed. Instead of deferring income and accelerating deductions, the new game plan is to accelerate income and defer deductions. Non-AMT deductions are worthless, and any income is going to be taxed at a flat 26% or 28% rate.

Here's what you might consider to accelerate income:

• Take a prepayment of salary or bonuses.

• Redeem Series EE U.S. savings bonds or certificates of deposit.

• Recognize short-term gains on portfolio securities.

• Withdraw funds from tax-deferred investments if the anticipated future rates exceed current taxation.

Here's what you might consider for deferring non-AMT deductions:

• Defer making your estimated state income-tax payments until the next year.

• Defer paying your real-estate or personal-property taxes until the next year.

• Defer any medical expenses if the total doesn't exceed 10% of your AGI.

• Defer payment of any employee business expenses, union dues, job-education, investment and tax-preparation expenses.

• Spread the exercise of any incentive stock options over a multiyear period to minimize the amount of preference items in any single year.

Since these deductions aren't allowed in the computation of the AMT, if you're subject to that tax, those deductions are worthless at tax time.

The key to a successful defense against the AMT is planning. Your 2006 return will give you a good idea about whether you will be hit with the AMT on your 2007 taxes.

So, start to do your 2007 projections and begin considering the strategies and techniques I suggested to minimize your potential tax exposure in 2008. You can even think ahead to 2009.

You know the AMT is out there. You've been warned.

Updated Dec. 27, 2007