Fall 2005

The Alternative Minimum Tax (AMT) continues to raise its ugly head for more and more taxpayers.

No, the rules haven’t changed. But unless Congress enacts legislation this coming fall, the temporary higher AMT income exemption amount that is currently in place will expire at the end of 2005.

The net result is a projected five-fold increase in the number of taxpayers impacted by AMT for the 2006 vs. the 2005 tax years. These estimates come from the Tax Policy Center which projects about 3 million taxpayers in AMT territory in 2005, increasing to nearly 15 million in 2006.

To add insult to injury, the AMT tax calculation method disallows some home mortgage and home equity interest deductions that are allowed when determining taxes the "regular" way.

Revenue Ruling 2005-11, issued by the IRS this past March, clarified the limited deductibility of mortgage interest for taxpayers subject to AMT.

Given the recent flurry in low-interest-rate refinancing and home equity loans, these AMT rules may surprise a number of folks who otherwise believed that all residence-related interest payments are deductible for federal tax purposes.

First, some review. For home-related debt secured after October 13, 1987, the IRS defines two types of indebtedness.

The first is acquisition indebtedness, which is a loan to acquire, build, or substantially improve a residence. Interest on acquisition indebtedness for loans up to $1 million is deductible for taxpayers who itemize their deductions.

The second is home equity indebtedness, which is any kind of borrowing against a residence that is not used to acquire, build, or substantially improve that residence. Interest on home equity indebtedness for loans up to $100,000 is also deductible but only for regular tax purposes.

Home equity indebtedness interest is not deductible for AMT taxpayers. When a taxpayer becomes subject to the AMT, home equity indebtedness deductions must be added back to income. (Note that this applies only to federal taxes. New York State income taxes are unaffected.)

Some examples of loans that may have a component of home equity indebtedness include home equity loans and home equity lines of credit. But there is nothing automatic here. The key is "what was the loan used for?". If a home equity line of credit is used, say, to improve a home, it is considered acquisition indebtedness and is deductible for AMT purposes.

Mortgage refinancing works a little differently. If a mortgage was originally considered to be entirely acquisition indebtedness, any refinance of that mortgage will continue to be considered acquisition indebtedness up to the extent of the remaining balance on the original mortgage just prior to refinancing, regardless of how the money is used.

But, any additional indebtedness will follow the use rules. If the additional amount is not used to substantially improve the residence, the loan will be considered home equity indebtedness, subject to the $100,000 loan interest-deductibility limit for regular tax purposes or non-deductibility for AMT purposes.

An interesting twist is that this issue is mostly on the honor system. Generally, lenders do not ask nor document how the loan proceeds are used by the borrower. The Form 1098 sent each January to borrowers for tax purposes does document that the loan is against the value of the residence but does not distinguish between acquisition and home equity indebtedness. It is up to the taxpayer and tax preparer to make that distinction and, for the latter type of indebtedness, follow the $100,000 loan value limit for regular taxes or the non-deductibility rule for AMT.

It is not unusual for a taxpayer to carry a mix of the two types of indebtedness within a package of one or multiple loans. For many taxpayers, it doesn’t matter. But if you’re into AMT, it matters a lot.

Confused? Don’t feel bad. Most people are. Rely on your financial planner and tax professional to understand the intricacies of the rules and to resource you in your decision making and tax preparation. It is particularly important that residence-related loans be properly structured to preserve beneficial tax treatment for the duration of the loans.