2005-01-13 / Business & Finance

Beware The Alternative Minimun

“I’m from the government and I’m here to help.”

You’ve been absorbing information from the various media regarding the recent tax cuts, you might believe the above sentence to be true. However, there is a caveat—the Alternative Minimum Tax (AMT). The AMT is a device that was created to catch those taxpayers who used “taxshelters” to reduce their income tax back in 1969. Now, there are tax shelters and there are Tax Shelters. The ones that you read about today are generally reprehensible, as they are either outright accounting shams or offshore schemes. Still, there was a time when tax shelters were more benign.

Interestingly, they were the result of a Government policy that rewarded taxpayers for investing their money in activities Congress believed needed stimulation. In the 1970’s and early 80’s people could invest in real estate, oil & gas, equipment leasing, cattle raising, et al, and receive an income tax deduction for the amount of the investment. Through leverage (borrowing), the deduction could be two, three, or four times the contribution!

As an example, if you had taxable income of $100,000 and you invested $50,000 in an approved real estate, oil & gas or equipment leasing program, your taxable income was only $50,000 because you got an income tax deduction for the $50,000 investment. If you used leverage, your income tax deduction could be $200,000! (Ah, for the good old days)

As you might imagine, this opened a Pandora’s Box because people began throwing money into lousy deals. The economics of the investment didn’t matter; investors only cared about the tax write-offs they received. To cure the ill, Congress used a one-two punch combination. The left jab, which sets up the knockout punch, was the creation of the AMT, a system that penalized those who received income tax write-offs by subjecting them to an alternative income tax calculation.

The right hand haymaker, delivered in 1986, was the Tax Reform Act of 1986 (TRA 86) that eliminated income tax deductions based on investments, retroactively. The law was crafted by New Jersey Senator, “Dollar” Bill Bradley.

The law did eliminate tax shelters; however, it used an elephant gun to kill a fly. For the first time current programs weren’t “grandfathered” in. The law was retroactive, so investors who began a program under one set of rules found that the rules changed, drastically, in the middle of the game.

Here’s what happened.

Typically, these programs had multi- year pay-ins. As an example, an in-vestor began a four-year pay-in real estate office-building program in 1984. They contributed money that year and received a tax deduction, they continued in 1985 and received the same. However, in 1986 they discovered that they would not get a tax write-off for investing in the program because of the retroactive tax law change. What did they do? They breached the contract and refused to make the contributions due after 1986.

Most of these transactions were faci-litated through general partnerships, so the general partner, the one who ran the program, declared the program bankrupt and the real estate project was terminated. This happened across the country. As a result, the real estate market went into the tank for ten long years.

Does anybody remember what happened to the stock market in 1987? I’ll give you a hint— October 19. Right! That was Black Monday: the market went down 512 points, losing over 25%, in a single day. Do you think the Tax Reform Act of 1986, the one that pull-ed the rug out from under investors, had anything to do with the market crash? You bet it did!

Well, since the passing of TRA 86, Uncle Sam has given up trying to micromanage the economy through income tax incentives; however, the AMT is with us. Although the calculation of the AMT is quite complicated, here it is in a nutshell. It is a second income tax calculation that has to be made if you have certain deductions. The highest tax rate for the AMT is lower than the highest tax rate for Regular Income Tax. However, there are fewer permitted deductions for the Alternative Minimum Tax. Thus, when AMT applies, the AMT taxable income, fewer exemptions, is much larger than the Regular Tax taxable income. So it is no surprise that a report from the Urban Institute said the following:

Historically, both the original minimum tax and the individual alternative minimum tax (AMT) that replaced it applied to only a small minority of high income households. But under current law, this “class tax” will soon be a “mass tax.” Current projections show the number of AMT taxpayers skyrocketing from 1 million in 1999 to 3 6 million in 2010. Without reform, virtually all upper-middle-class families with two or more children will be paying the AMT by decade’s end. This expansion will occur because the AMT is not indexed for inflation and be-cause the 2001 tax cut reduced the regular income tax without making long-term cuts to the AMT.

In general, the art of government consists in taking as much money as possible from one party of the citizens to give to the other.

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