The scoop on AMT (Alternative Minimum Tax)

Remember the old tag line from the show "Lifestyles of the Rich and Famous", as Robin Leach wished us all "champagne wishes and caviar dreams"? And sure enough, these days more and more people have the trappings of the rich. But is it the new home, maybe a shiny BMW, or more vacations? No. It's getting hit by the AMT or Alternative Minimum Tax, originally designed to hit only the ultra-wealthy. Not really the "you have arrived" feeling you had hoped for.

The nasty AMT isn't just for the wealthy anymore, as it is trapping an alarming amount of the middle class, especially those who own homes and live in states with high income tax rates. And it's getting worse. Pretty soon, over half those with incomes between $75k - $100k will be victimized by the AMT.

So what's the scoop with AMT, and what do we need to watch out for?

The AMT was first enacted nearly 40 years ago to ensure that wealthy taxpayers pay at least some federal income tax versus sheltering their entire income with big write-offs. This strategy worked at the time, but AMT has never been indexed for inflation, resulting in more middle-income taxpayers owing the additional tax.

All of us go through the AMT test each year. Our income is matched up with the tax brackets it falls into and the tax owed is calculated. But we also go through a second calculation - The AMT calculation. Many deductions are eliminated and the tax brackets are reduced. The tax owed under AMT is then compared to the tax owed under the bracket calculation. And guess which one you owe? The higher tax, of course.

More individuals will pay the higher AMT tax since it does not allow deductions such as certain interest on some home loans, property taxes, state and local income taxes, standard deductions, or personal exemptions for children and dependents that are normally deductible under the regular tax brackets. As stated earlier, certain interest on some home loans will be wiped out under the AMT. There are two types of home loans that can be eligible for tax deductibility.

First, there is Acquisition Debt, which allows interest to be deductible on a loan used to acquire or improve your primary or second home, with a loan limit of $1 million dollars. The good news about Acquisition Debt is that it remains deductible, even if you are subject to AMT. This makes Acquisition Debt very valuable. But once you pay off or reduce the balance of your Acquisition Debt, it is gone and only the interest on the remaining portion is deductible. So taking out a new loan at a higher amount will not give you that precious Acquisition Debt back.

The next best thing to Acquisition Debt is Home Equity Debt. Home Equity Debt has a limit of $100,000, which can be used over and above the Acquisition Debt Balance. And Home Equity Debt is flexible in that you can pay it down and pull it back out, which is not allowable for Acquisition Debt. But Home Equity Debt is eliminated under AMT...ouch. And with so many people being trapped by the AMT and also having loan amounts higher than what was used to acquire the property, the lost deduction is significant.