Your 2007 Taxes: Watch out for the AMT trap

February 1, 2008

The alternative minimum tax makes mincemeat of your deductions-and it's nabbing more and more professionals.

Key Points

If you're happily anticipating that all of your juicy tax deductions could save you big bucks this year, don't smile too soon. A doctor who has $180,000 of taxable income could owe about $45,500 under our usual tax structure-but perhaps $55,000 to $60,000 under the alternative minimum tax, which is reeling in more and more upper-middle-class folks.

The AMT is like the Godzilla of the tax code: Everyone knows it needs to be changed, but no one's quite sure of the best way to go about it. Originally designed to ensure that fat cats pay their fair share of taxes, the AMT has begun to stomp on the finances of regular folks, including primary care doctors trying to earn a decent living in an ever-tightening market.

"No doubt, more and more people are getting hit with the AMT," says CPA David Polstra, a financial adviser with Brightworth in Atlanta. "One reason is that the regular tax rates have come down over the years, but the AMT rates have stayed the same. So more people have a lower tax liability under the regular tax code than they'd have under the AMT. That's when the AMT kicks in."

Who's at risk for the AMT?

The AMT most often nabs people who earn at least $100,000 and claim big deductions that allow them to pay less in taxes than the government thinks they should. "The deductions are legal, but the AMT lurks in the shadows to assure that all citizens pay their fair share," Polstra says. "It takes many of the itemized deductions that lower your adjusted gross income and adds them back to your AGI." For instance, interest of up to $100,000 on home-equity loans is generally deductible even if you don't use the money for home improvements. Not so with the AMT.

In addition, the AMT wipes out deductions for property taxes and those for dependents, so it has a bigger impact on families with kids than on childless couples. If legislators continue to fail to enact sweeping reforms, the percentage of married families with two or more kids and an AGI between $75,000 and $100,000 who get dinged by the AMT will skyrocket from less than 1 percent in 2006 to 89 percent in 2010, according to the Tax Policy Center, a joint venture of the Urban Institute and Brookings Institution.

The news is only slightly better for higher-earning households, which include many doctors. Unless Congress acts to scale back or eliminate the alternative minimum tax instead of issuing a series of temporary "patches," more than 80 percent of households with incomes between $100,000 and $200,000 will pay the AMT by 2010, says the Tax Policy Center. In 2006, less than 5 percent of this group got snagged. (Since 2001, Congress has periodically adjusted the exemption levels and credit rules to keep the number of AMT taxpayers at around 4 million.)

Residents of states with high income taxes, like New York and California, may also be prime targets for the AMT, says accountant Gene Price, of Price & Rosenberg in Bardonia, NY. "People use high state income tax payments to reduce the income taxable at the federal level, but that's the type of situation that the AMT catches," he says.

Investments are counted differently

In the regular tax code, you're not taxed when you exercise an incentive stock option. Under the alternative minimum tax, however, you'll pay tax on the difference between the fair market value of the stock and the exercise price of the option. Under the usual rules, you wouldn't owe anything on this "spread."

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