INDIVIDUAL Will 2007 Be the Year Congress Reins in the AMT?

Nearly 25 million American taxpayers will be staring down the barrel of the Alternative Minimum Tax (AMT) when they file their 2007 income taxes. That’s more than a fivefold increase from 2006, when four million taxpayers paid the AMT.

Already restive, taxpayers will boil over if the AMT bites that many people. For that reason, Capitol Hill watchers expect to see congressional action before year end.

Think of the AMT as a parallel tax system intended to make certain that the wealthy don’t avoid income taxes through certain itemized deductions and other preference items. The AMT accomplishes this by eliminating the ability to claim deductions and credits such as state and local tax deductions, property taxes, personal exemptions and the child tax credit if your tax bill falls below a certain threshold. In 1970, the year the AMT went into effect, only 19,000 taxpayers paid the higher AMT. However, when it passed the AMT, Congress neglected to index it for inflation.

With inflation, the meaning of “wealthy” in the context of the AMT has changed. Taxpayers earning $75,000 – hardly wealthy – can get hit with the AMT depending on their circumstances.

Here’s why the AMT is biting an increasingly larger number of taxpayers. In the “regular” tax brackets, the IRS adjusts exemptions and standard deductions annually for inflation. However, the AMT brackets and exemptions are the same as they were in 1969, when the AMT was enacted by Congress. Especially vulnerable are people with income over $75,000 and some large deductions, but not the exotic deductions that were originally targeted by the AMT’s creators. Most vulnerable are taxpayers with several children, interest deductions from second mortgages, capital gains, high state and local income taxes and incentive stock options. The only way to know whether you will owe the AMT is to run the numbers, which essentially means doing your taxes a second time. If your AMT tax liability is greater than your regular tax liability, you owe the higher AMT amount.

Under the AMT regime, certain deductions and exclusions are lost. Some common deductions such as personal and dependent exemptions – and the standard deduction, for those taxpayers who do not itemize their deductions – are not allowed for AMT purposes. Also lost is the ability to deduct state and local income taxes and property-tax payments, as well as your home-equity loan interest, unless the loan was used for home improvements.

Other items that lose their deductibility are some investment and employee business expenses, as well as some medical and dental expenses. Furthermore, interest earned on certain municipal bonds, so-called “private activity” bonds typically used to finance projects like sports stadiums, lose their federal tax-free status for AMT purposes.

Doing anything about the AMT will be challenging in light of the fiscal austerity pledges made by House Speaker Nancy Pelosi (D-Calif.) and key Senate Democrats. They are promising to tighten federal budget rules so that the cost of any tax relief must be offset by corresponding spending cuts or by other tax increases.

Why not just repeal the AMT? For one thing, repeal would blow a $30 billion hole in a federal budget that is already deeply in the red. Moreover, public debate over the growing income gap between the wealthiest Americans and everyone else makes the repeal a dodgy proposition without enactment of other anti-tax-shelter measures.

Given the budgetary impact that repeal would have, don’t expect Congress to overhaul or scrap the AMT. The more likely outcome is the “freeze” scenario, as the congressional Democrats bide their time and wait until after the 2008 Presidential election before pursuing a broader tax agenda.

For more information, please contact Sherry Reisch at sreisch@gellerco.com.