The Alternative Nightmare

Tax planning is a year-round event for the upper middle class.

Thinking about taxes at the end of summer? For most people, there are only two times of year when they want to deal with the IRS: at year-end, when they can shore up their tax planning for the year, and in that dread season leading up to April 15. But there’s a creeping terror that has really made tax planning a year-round event for the upper middle class: the alternative minimum tax. According to one study, 83 percent of all taxpayers with income between $200,000 and $500,000 had to pay the AMT this year.

That’s an awful lot of people whose normal tax planning got kicked in the teeth. While the AMT has a logical founding—it ensures that wealthy people can’t find so many loopholes that they end up owing nothing in federal income tax—its execution has become extremely troublesome.

How did we get to this state of events, where upper middle class people are so burdened by something that was initially intended to affect only the wealthy? The biggest mistake early on was that the AMT was not indexed for inflation. Occasional adjustments to the exemption amount haven’t really helped the AMT from creeping into the lives of midtier taxpayers. Even though it went up temporarily in 2005, the exemption amount was still only $58,000 for couples filing jointly. That’s not the wealthy! Anyone who made more than that was subject to having an entirely different method of tax calculation imposed on them and having to pay 26 or 28 percent of his or her income in federal tax—regardless of deductions or tax planning.

The Best-Laid Plans

The AMT and you.

What is so insidious about the AMT is the way it plays havoc with your tax strategies. If you qualify for the AMT, you have to refigure your income without many of the deductions and exclusions that apply to taxable income under ordinary rules. You cannot deduct state and local taxes under the AMT, nor can you deduct interest on a second mortgage. Since many of us invest in real estate in large part for the tax benefits, it can be very frustrating to see those deductions go away.

Or consider tax-exempt bonds: Under the AMT, many of them aren’t. Despite the fact that they are designed and marketed according to the tax advantages they provide, tax-exempt bonds that invest in so-called private activities lose their tax advantages when the AMT is invoked. Private activities are generally those things referred to as project bonds, issued to fund such things as airports or industrial projects. Even long-term capital gains may not get favorable treatment under the AMT.

Easing the Pain

Tax planning strategies to help investors.

So the next question is, what can I do to avoid triggering the AMT? There isn’t very much you can do to avoid it altogether, but there are steps you can take to reduce its bite. Consider the following:

  • Take as much money as you can as regular income, as opposed to capital-gains income.
  • Defer deductible expenses, such as medical expenses or fourth-quarter state income taxes, if you think your income might be lesser in the following year.
  • Be careful about exercising stock options. Consult with your wealth manager or tax professional to make sure the timing is optimal for the tax implications.

Above all, make sure you are aware of the AMT before you start any of your tax planning for the year. The AMT is truly an alternative tax structure, one in which the general tax rules no longer apply. But as long as you and your advisors are conscious of it, it doesn’t have to add to your April 15 nightmares.

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