Beware the AMT

If you pay quarterly estimated state income taxes or have a real-estate tax bill due in January, you can pre-pay it this month and boost your deductions on your 2008 federal tax return. But beware. If you're among the growing number of taxpayers ensnared by the alternative minimum tax, this sooner-than-later strategy won't work for you.

The AMT is a parallel tax system with its own set of rules. Originally designed to make sure wealthy people could not use legal deductions and loopholes to drive their tax bill to zero, the AMT is now increasingly affecting the middle class.

The AMT does not allow deductions for state and local taxes, home-equity loan interest (unless the borrowed money was used for home improvements), or items such as investment expenses. Nor does it allow personal exemptions -- worth $3,500 this year -- for yourself, your spouse and each of your dependent children. So you pay taxes on a larger portion of your income even though the AMT rates of 26% and 28% may be lower than your regular tax rate.

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Essentially, you have to figure your taxes under two sets of rules -- the regular tax code and the AMT -- and pay whichever is higher. Regular tax brackets are indexed for inflation but the AMT isn't. Consequently, your chance of being trapped by the AMT increases each year, particularly if you claim large deductions for state income taxes or property taxes or have a large family.

For the past several years, Congress has approved temporary patches to boost the income level of taxpayers subject to the AMT. This year was no exception. As part of the $700-billion economic rescue package, Congress approved a one-year patch that increases the AMT exemption to $69,950 for married couples and $46,200 for individuals.

The new higher exemption levels will prevent about 21 million new taxpayers from being hit by the AMT in 2008. But it’s a safe bet that if you’re among the more than three million taxpayers who paid the so-called "stealth tax" last year and your financial situation hasn’t changed substantially, you'll probably be caught again this year.