Congress has made the news in the last couple weeks for it’s inability to fix AMT, the Alternative Minimum Tax.  The alternative minimum tax was established in the late 60s (1969) to prevent the uber wealthy from continuing to exploit the many tax loopholes that existed from paying little or no taxes. Not only were many these tax loopholes closed during the tax reform of 1983, but more critically the levels at which AMT kicks in were never adjusted for inflation.  Because the levels were never adjusted for inflation, the AMT impacts many upper middle class families.

In the last few years, Congress has typically enacted temporary measures preventing the AMT from hitting a wider swath of the middle class.  However as we head towards the end of the year, Congress is split along partyl lines. Democrats want to tie any reduction in AMT revenue with a corresponding increase in tax revenue somewhere else. Republican congressman do not support such proposals, and President Bush has vowed to veto any tax bill that includes any tax increases.  As a result there is deadlock.  Personally I do think if we are going to fix the AMT problem, in the long run we will have to either raise taxes somewhere else or cut spending.  I’d probably prefer a little of both.  While the two different political parties may not agree on the solution, they do agree that something needs to be done. For that reason, I’m hopeful we will have at least another temporary fix by the end of the year. Personally, the AMT does not affect me. Being unmarried and without children, I don’t have quite enough tax deductions to be affected.

So who does the AMT affect? Primarily high income families in high tax states. In essence what the AMT is intended to do is ensure that citizens are paying some minimum level of taxes even after taking allowable deductions. This made much more sense in 1969 when there were numerous and egregious tax deductions that allowed many of the wealthiest families in America pay little to no taxes even though the top tax bracket was much higher than it is currently. The top tax bracket in 1969 was 70% versus 35% today. The AMT was really intended for the richest 155 families who were not paying their fair share of taxes.

So what can one do to avoid the AMT? While in many ways it’s very easy to avoid the AMT, it actually doesn’t make sense on the most part to actively avoid. Avoiding the AMT, generally means avoiding tax deductions. Not having deductions means paying more taxes under the standard tax code. That’s the beauty of AMT, it doesn’t kick in unless it means you’ll be paying more in taxes. An upper middle class family in high tax state with a few kids and a McMansions ends up being hit with the AMT because right off the bat they often have the following deductions (but not limited to).

  • State and Property Taxes
  • 2nd Mortgages/Home Equity Lines
  • Dependents
  • Medical Expenses

Other less common but potentially more odious complications are:

  • Stock Options - Under AMT you pay taxes on difference between the market price and the strike price at the time of exercise
  • Depreciation - This is important for business and property owners who pass depreciation into their personal taxes
  • Misc. Itemized Deductions

All these deductions can reduce the effective tax rate below 28% at which point AMT kicks in.  AMT ensures that wealthy tax payers are paying at least around 28%.  Personally, I prefer a more transparent tax code that ensures everyone pays his or her fair share in taxes.  The AMT partially serves that goal, but far from a transparent manner, hence being named the “stealth tax.”  One reason the Government is loathe to solve the AMT problem is that it has basically allowed it to give with one hand and take with the other.  For example the 2000 tax cuts by themselves should’ve been a great boon to upper middle class families, but for many families it just meant they ended up paying the AMT.  There was still a substantial tax cut for the rich, but not as much as advertised for the moderately so.  The key is not avoiding AMT, but ensuring your tax foot print is minimized both under the regular tax code, and under AMT.

The most notable and seemingly arbitrary difference in treatment under AMT versus the standard tax code is related to municipal bonds.  Typically income from municipal bonds are exempt from local (assuming you live from the state the bonds originate) and federal taxes, however income from “specified private activity” municipals bonds fall under AMT while “general obligation” bonds do not.  For example let’s say I held bonds issued by the State ofMassachusetts to construct a new waterfront stadium that gave off income of 100 thousand dollars a year, and had no other income source. Under the regular tax code I would owe nothing in taxes, however under the AMT I would owe almost 28% because a stadium is considered specified private activity.  However, I could’ve easily held instead “general obligation” bonds issued by the state that would not be subject to the AMT.  General obligation bonds are simply debt issued by local governments not tied to any specific project.  The other deductions that are treated favorably under AMT are mortgage interest (on a primary home), and charitable giving.