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How The AMT Wallops Capital Gains

Karen Brosi, a financial planner in Palo Alto, Calif., is tired of delivering bad news. She had to do it over and over during this tax-filing season. A middle-income client would walk into her office, having sold a pile of stock. He thought he was going to pay only the 15% rate on his investment profits, thanks to the 2003 tax cut.

But Brosi had to report that because of the alternative minimum tax, effective rates on gains can actually top 21%. "These are people who have never seen the AMT," says Brosi. "They are walking along thinking they are going to have to pay Uncle Sam 15%, then their return gets done. All of a sudden it's going to cost them a lot more."

This has been a problem since capital- gains rates were trimmed in '03, but it's about to get worse as millions more taxpayers fall under the AMT. In 2006, as many as 4 million investors may find themselves caught in this AMT trap, according to congressional estimates. That's twice as many as last year. And while many may not know it, they have been stuck in the middle of a battle on Capitol Hill over whether to extend the low rates on capital gains and dividends or overhaul the poorly understood AMT.

The AMT was first passed in 1969 to prevent the very rich from avoiding taxation altogether by taking numerous deductions. It requires people to do their returns twice: once the regular way and once without many deductions -- and then pay whichever tax is higher. Because Congress has failed to adjust the AMT for inflation, it now hits many in the upper-middle class. The Urban-Brookings Tax Policy Center estimates that nearly 64% of those making $100,000 to $200,000 could face the AMT in 2006.

For months, Congress has been trying to figure out which tax issue to address first. Short of both time and money, lawmakers have been arguing over whether to limit the AMT or extend the 15% rate on capital gains and dividends, which is due to expire at the end of 2008. President George W. Bush and many Hill Republicans say they are closing in on a deal that would extend the low cap-gains rates until 2010 but curb the AMT's reach for only this year.

Ask investors which problem they would rather see Congress address, and most would probably vote for capital-gains relief. But for many under the shadow of the AMT, that would be a bad choice. Not only are millions of investors paying higher taxes today than they expected, but many are also paying more than they did in 2002, when gains were taxed at 20%. "Politicians gave you a broken promise," says Frank Degan, a licensed tax preparer in Setauket, N.Y. "They told you they were lowering your taxes, but they did not."

Shrinking Exemptions

The AMT does not directly raise the cap-gains rate. Instead, the more gains people have, the higher their overall taxes climb, because of the AMT.

Here's why: If you are in the AMT, you get to exempt some income from the tax. This year, married couples can exclude their first $45,000 in AMT income. But once you make $150,000, the value of that $45,000 exemption starts to shrink. Because gains are included in AMT income, those investment profits slash the exemption, and you must pay more taxes. To make matters worse, if you are in the AMT, you no longer can deduct any state and local taxes you paid on your capital gains. That raises your effective federal tax rate even more. Says Jennifer MacMillan, a licensed tax preparer in Santa Barbara, Calif.: "In a lot of cases, it's people who have a one-time gain and don't have a lot of other income."

A married couple that made, say, $170,000 in ordinary income and $100,000 in capital gains would pay taxes of 21% or 22% on those profits, according to a study by Wake Forest University business professors Yvonne L. Hinson and Ralph B. Tower. One more nasty AMT gift: Those people must fill out 65 extra lines on their capital-gains form, Schedule D.

To add insult to injury, the rich don't have these problems. The impact of the AMT shrinks in the very top brackets, so by the time investors make $1 million, they are paying an effective rate of about 16% on their gains.

If Congress doesn't act, the AMT will affect 20 million taxpayers in 2006. Many will feel blindsided next Apr. 15.

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