A dreaded tax is slated to be fixed

Lawmakers have vowed to revise the alternative minimum tax, which is imposing higher taxes on 4 million middle-class households this year.

If you think your taxes are bad this year, wait until next April 15.

Unless Congress acts relatively soon, millions more Americans will find that the tax refund they expected will disappear – swallowed up by the alternative minimum tax (AMT), a levy originally designed to make sure that millionaires pay up.

Indeed, as Americans root through receipt-filled shoeboxes to complete this year's 1040, fixing the AMT has become a priority in Congress. Lawmakers on both sides of the aisle agree something must be done, and they agree a fix will mean billions of dollars in lost revenue for US coffers. But there's little agreement on how to pay for the repair: Many Democrats envision a tax increase for the wealthy, while many Republicans favor the elimination of some broad-based deductions, like local tax exemptions. The two sides don't even concur on how much revenue will be lost: Some put the figure at as little as $250 billion over the next decade, others as high as $1 trillion.

Given the lack of consensus, the first question lawmakers will be haggling over is whether to do a one-year "patch" of the tax to give middle-income homeowners a break or to try for a long-term overhaul.

Lawmakers feel sense of urgency

Either way, congressional leaders say something will be done to fix the problem.

"It's very important. It's my No. 1 priority," says Rep. Charles Rangel (D) of New York, chairman of the House Ways and Means Committee.

The committee's ranking Republican, Rep. Thomas Reynolds of New York, agrees the AMT must be tackled this session. "If we don't do something to fix this on a permanent basis, it's not just going to affect high-income, high-tax states, ... it's going to engulf middle-class taxpayers throughout the country."

Many Americans have already felt the sting of the AMT as it has spread into the middle class:

•Margaret Rauh, a tax preparer by profession, likes to figure out her taxes a year in advance – to sort of imagine what she, her husband, and three young children might do with her tax refund. But this year, when she looked ahead, she found herself sitting with her mouth agape: The money she would ordinarily use for a vacation or to buy a piece of furniture will not be there. Instead, her family's annual income of $75,000 would be subject to the AMT. Unless something happens, she says, "something will get cut from the family's budget."

•With one child in college and another about to start, Joel Campbell, a middle-income sales director in Virginia's Loudoun County, has already tightened his belt. He says his property taxes are rising at double-digit rates annually – something he can no longer deduct from his income taxes now that he's subject to the AMT. Paying any additional tax to Uncle Sam will force some austerity measures.

"If something's not done, he'll end up paying $1,000 more in [federal] taxes next year," says Art Auerbach of Goodman and Co. in McLean, Va., Mr. Campbell's accountant.

Four million hit by AMT this year

An estimated 4 million Americans will be subject to the higher AMT this year. The number would have been 11 million, but Congress approved a temporary patch last year. Unless lawmakers apply another patch or pass a comprehensive reform, that number will jump to as many as 23 million people for the 2007 tax year.

"They're suffering from a problem that nobody really intended to incur and which nobody has gotten around to fixing," says Alan Viard, a scholar at the American Enterprise Institute in Washington.

Think of the AMT is a kind of shadow tax system. It was enacted in 1969 as a way to ensure that the richest Americans, if they used legal loopholes to avoid taxes, would end up paying at least something.

Two calculations of the tax bite

This is how it works: Households with annual income above a certain threshold – set last year at $65,000 – must calculate their tax liability two ways. First, they calculate their tax liability using the regular tax code, which allows for deductions for mortgage interest, state and local taxes, and other items. Then, they must recalculate it under the AMT, which does not allow for most of those write-offs. The taxpayer shells out to the IRS whichever number is highest.

The problem is that the AMT threshold was never indexed to inflation. As a result, more middle-income Americans like Ms. Rauh are getting snagged by it. For many, that means their mortgage-interest deduction, which might have saved them thousands of dollars in taxes in the past, suddenly no longer counts.

"It surprises people. It comes out of left field, and a lot of people who never paid it don't know it's there," says Dennis Jacobe, Washington-based chief economist at the Gallup Organization. "Generally speaking," he adds, "people view the tax system as relatively fair, depending on where you sit in the income spectrum."

Representative Rangel's committee has held two hearings on the AMT already and expects to hold more this spring. His goal is to have a bill ready for a vote no later than June, according to his staff.

Some analysts expect that the best Congress can do this year is another patch, because the long-term solutions proposed by Democrats and Republicans remain far apart.

"At this moment I'm not sure there's a solution that would work for both of them," says Mr. Viard. "The Democrats are not willing to consider any base-broadening [that would do away exemptions], and the Republicans are not willing to consider any marginal tax increases. I don't really see any common ground there.

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