Going to Extremes to Avoid the AMT

The culprit: The Halsteads' annual income — a little over $220,000 — combined with their ownership of four rental properties, is throwing them smack in the middle of the dreaded alternative minimum tax trap. As a result, federal and state taxes are eating up more than 40% of their 2007 income, not to mention the fact that they lose some valuable deductions, including state and local income tax and property-tax write-offs.

If they were to divorce, however, Halstead could deduct the $48,000 in alimony payments he'd make to his wife and lessen the AMT hit on his $170,000 income. His wife, with only $50,000 in earnings, would avoid the AMT altogether. And, at that point, they could even deduct most of their rental property losses — nearly $30,000 for this year — which would further increase their tax savings.

For better or for worse, Halstead's wife isn't the divorcing kind. "We're pretty traditional and she wouldn't have it," he says. Their five daughters, he adds, would also be "overly upset if Mama and I got divorced."

So instead of family court, Halstead flew to Florida a few weekends ago, arranging for the sale of one of the rental properties that was supposed to generate part of their future retirement income. Getting rid of the house now, even at a loss of $40,000, he reasons, would make more sense over the long term since most of the deductions associated with it aren't allowed by the AMT anyway.

Such are the unintended consequences of the AMT. Introduced in 1969, this alternative taxation system was designed to prevent the wealthiest Americans from taking so many deductions that they end up paying little or no taxes at all. But while the regular tax system is indexed for inflation, the AMT is not. Once intended for America's highest earners, the AMT now hits more middle-income folks than ever before.

Only 20,000 taxpayers were subject to the AMT in 1970, according to research by the Tax Policy Center, a nonpartisan group. In 2007, it hit 3.5 million. Half of those taxpayers earned between $200,000 and $500,000 and another 5% earned less than $200,000. By 2010, the group says, the AMT will reach more than 80% of filers earning between $100,000 and $200,000 and half of those earning between $75,000 and $100,000.

Today, middle-income Americans are particularly vulnerable if they live in states with high property or income state taxes, since the large deductions — not allowed under the AMT system — trigger the tax, says Barbara Weltman, a contributing editor to "J.K. Lasser's Your Income Tax 2008." So are large families, just by virtue of claiming too many personal exemptions. "If you have a family with six children, you're taking a deduction of $27,200 for regular income-tax purposes that's not allowed under AMT," Weltman says. (For more details on how the AMT works, read our story.)

Because the AMT costs taxpayers an average of $2,000 more than they would owe under the regular tax system, according to Weltman, it's no surprise that many folks would do anything within their means — and the law — to avoid it. (That extra cost would be even higher were it not for the AMT patch that Congress passed for 2007.) Here are some other strategies people use to avoid getting hit by the AMT.

It's a strategy that may work for taxpayers who realize large capital gains in one year, but don't otherwise earn enough to be subject to the AMT. The catch: The longer they stretch those state tax payments out, the more penalties they'll have to pay, which could potentially offset the tax savings.

Tim Speiss, head of the Personal Wealth Advisors group at accounting firm Eisner LLP, says he's had clients move to Pennsylvania from New York or New Jersey in order to escape the AMT. "It's not that terribly far, it's easy to get to and it has a 3% income tax rate," he notes. "We have virtually no clients in Pennsylvania who pay the AMT, and it's primarily due to the fact that when the state tax is so low, the disallowance is not large enough to put someone in AMT."

One snag: A taxpayer who moves to another state, but keeps their old home as a part-time residence, Speiss warns, is at risk for an IRS audit. The IRS may suspect — rightfully so, in many cases — that the person still lives in the higher-tax state, but is maintaining a residence in another state to lower their tax bill, he explains.