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The Honolulu Advertiser

Posted on: Thursday, December 18, 2003

Alternative minimum tax lurking

By Sandra Block
USA Today

Millions of taxpayers will get a fatter refund next year, which is great news if you're eager to make some home improvements in 2004. But don't start ordering window treatments just yet. The Bush administration's tax cuts, the main reason many families will get a larger refund, will also force more taxpayers to pay the alternative minimum tax.

The alternative minimum tax, or AMT, was created in 1969 to prevent the super-rich from using elaborate loopholes to avoid paying taxes. But because it wasn't indexed to inflation, the number of taxpayers who fall into the AMT net has increased. In 2003, an estimated 2.4 million taxpayers will pay the tax. Unless Congress changes the law, up to a third of all taxpayers will grapple with the AMT by the year 2010.

The Bush tax cut exacerbated the problem because it reduced ordinary income tax rates but left AMT rates unchanged, says John Battaglia, a director with Deloitte, the U.S. arm of Deloitte Touche Tohmatsu, a financial services firm. While the Bush administration increased the AMT exemption amount for certain taxpayers, the AMT will still ensnare many upper-middle-income taxpayers who take advantage of widely used deductions.

AMT rates are 26 percent and 28 percent, depending on your income. While that may be lower than your standard income tax rate, the loss of certain deductions and exemptions will result in a higher tax bill.

The only way to know for sure whether you're a candidate for AMT is to prepare your taxes twice — once the old-fashioned way and a second time on IRS Form 6251.

The higher number is the amount you owe the IRS. It's sort of like taking your SAT tests twice and turning in the exam with the worst score. But if you file your taxes the regular way and the IRS determines you owe AMT, you could face underpayment penalties.

If you think you might owe AMT, run the numbers before year's end, either with help from a tax preparer or by using a tax software program. That way, you may be able to take steps to head off an AMT problem, says Jeffrey Hoops, president of the New York State Society of Certified Public Accountants.

Some AMT triggers:

• State, local and real estate taxes.

These taxes are typically deductible from your federal income tax. But they're also considered AMT "preferences" — which means they're disallowed if you're subject to the AMT.

Taxpayers often pay estimated state taxes due in January in December, so they can claim the deduction on the current year's tax returns. But that strategy can trigger the AMT. If your projections suggest you'll be subject to the AMT this year, it may behoove you to postpone paying state and local taxes until next year, particularly if you think the AMT won't be a problem in 2004, Battaglia says.

• Incentive stock options.

These options give workers the right to buy shares of their company's stock at a set price in the future. Stock options lost their luster during the bear market, but this year's gains have prompted many workers to exercise their options.

Many workers with incentive stock options exercise their options, then wait at least a year to sell so they'll pay the lower long-term capital gains rate on their profits. But under the AMT, the difference between the exercise and market price on the day you exercise your options is taxable, even if you don't sell the shares.

So tax advisers often recommend staggering the exercise of incentive stock options over several years to avoid triggering the AMT. A good tax preparer can help you devise a tax-friendly strategy.

• Miscellaneous itemized deductions subject to the 2 percent "floor."

These deductions, which include unreimbursed business expenses, tax-preparation fees and job-hunting costs, must exceed 2 percent of your adjusted gross income before you can claim them. And even if you breach that threshold, it's unlikely that miscellaneous deductions alone will force you to pay the AMT. But a large amount of miscellaneous deductions, combined with other disallowed credits and deductions, could trigger the tax. So to the extent you can control those deductions, try and take them in a year when you're less likely to owe the AMT.

Finally, be on the lookout for AMT traps. For example, many homeowners took out home equity loans and lines of credit this year to take advantage of low interest rates. Ordinarily, interest on those loans is deductible, making them even more attractive. But interest on a home equity line or loan that isn't used to buy, build or improve a home is disallowed under the AMT.

The key is to take charge of your taxes now, while there's still enough time to make changes that could help you avoid the tax, or at least reduce its impact.