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A March 6 Business article misstated what taxpayers must do to qualify for the exemption available when they sell their primary residence if they acquired that property in an investment-property exchange under Section 1031 of the tax code. The taxpayer must own the property for at least five years after the exchange and live in it for at least two of those years. The taxpayer does not have to live in the property all five years.

Tax Ambushes For the Unwary

Sunday, March 6, 2005; Page F01

A few snags you may hit on your journey through the forms:

• 1. The alternative minimum tax. Okay, you've done your return; you've taken all the deductions and credits you're entitled to; you've taken advantage of the lower tax rates that have been in effect in recent years, and things aren't looking too bad. So let's get that bad boy in the mail and out of mind, right?

_____Tax Time 2005_____
Numbers Crunch
Singletary: Fix Your Withholding
Find the Best Deductions
Tax Ambushes For the Unwary
Steps Toward A Happier Return
Ways to Reduce A Big Fat Tax
Off-the-Shelf Programs Secure Data
Complete Coverage/Resources

Not so fast.

You may have to go back and do the whole thing again, using different rules.

That is because anyone whose income is much above $40,000 for a single or $58,000 for a couple and whose return goes much beyond W-2 wages and the standard deduction may be subject to the alternative minimum tax. Originally put into the law to prevent wealthy Americans from using so many legal tax breaks that they ended up paying no tax, the AMT, thanks to inflation, has slowly but steadily broadened its reach down the income scale and into the middle class.

In simple terms, the AMT is a parallel tax system in which a number of benefits, such as personal exemptions and the deduction for state and local taxes, are eliminated; a special, large standard deduction ($40,250 for a single; $58,000 for a couple) is applied, and the tax is computed using two brackets of 26 and 28 percent. A taxpayer is supposed to compute his or her tax the regular way and the AMT way and pay whichever is larger.

The AMT is full of traps all its own. For example, said Art Auerbach, a CPA with Goodman & Co. in McLean, interest on a home equity loan, which is deductible up to $100,000 for regular tax, is not deductible on the AMT unless the money was used to buy, build or improve your home.

Most computerized tax preparation programs will do the AMT calculations for you, and some do so automatically. So if the program comes up with a weird high number for your tax, that may be the result of the AMT. If you are a pencil-and-paper person, you should at least do a rough cut to see if you may have an AMT liability, and then do a careful one if it appears that you do.

2. Depreciation recapture. In recent years, homeowners and small-business owners have been treated to special tax breaks that can be extremely beneficial. Homeowners who sell are now allowed to exclude from tax large amounts of profit if their houses have appreciated, as many have. Under the rules, up to $250,000 for a single taxpayer and $500,000 for a married couple is free of federal, and in many cases state, income tax.

Owners of small businesses have been granted big write-offs on the purchase of equipment, including reported, big sport-utility vehicles. But both home and business owners have to be careful. If a homeowner has taken depreciation, such as for a home office or rental unit, since 1997, those amounts are not exempt from tax, and are subject to a special tax rate of as much as 25 percent.

Likewise, if you are a business owner who bought a big SUV in the past couple of years and wrote the entire cost off under the provisions that were then in effect, your "basis" is now zero. Basis is the tax term for the amount you subtract from what you receive when you sell an asset in order to calculate whether you have a gain or loss. The basis is typically the purchase price plus commissions for assets like stocks, but when you take depreciation deductions, as you can on business equipment, your basis goes down. Thus, if you sold your big SUV, the money you got for it could be taxable. For example, if you sold your big $75,000 SUV for $50,000, you would not have a $25,000 loss but a $50,000 gain -- if you wrote the whole purchase price off your taxes in the year of purchase.

• 3. Limitation on 1031 property. Caution: If you don't know a like-kind swap from a wife-swap, feel free to skip to the next item. But there is a way around the depreciation problem and/or the limitation on the amount of excludable gain from the sale of a home. It is to use the "like-kind" exchange provision in Section 1031 of the tax law. But last fall Congress put a limit on this game.

Taxpayers had figured out ways to combine the residential exclusion with the 1031 to exclude some gain, defer tax on the rest while acquiring a second property, then move into the second property and reuse the residential exclusion. Now, if you live in a property you acquired in a 1031 exchange, you have to live in it five years instead of two to be allowed to use the residential exclusion. This provision applies to sales or exchanges after Oct. 22, 2004.

The strategy remains generally available; it just takes longer. But if you were living in a house that you got in a 1031 exchange and you sold it between Oct. 22 and Dec. 31, 2004, you may have to pay tax on it for 2004. If you sold it since, you may have to pay tax for 2005. If you haven't sold, you may want to hold it until 2009, or use Section 1031 again.

• 4. PEP and Pease. As taxpayers reach what might be called the well-to-do level by Republicans, and rich by Democrats, two special provisions begin to bite, reducing the benefits they receive from personal exemptions and itemized deductions. These are known as PEP (personal exemption phase-out) and Pease (after Rep. Donald J. Pease [D-Ohio], who inserted the limitation on itemized deductions into the 1986 tax reform bill). Personal exemptions, worth $3,100 apiece for 2004, begin to phase out at incomes of $142,700 for single people, $178,350 for heads of household and $214,050 for married couples. This creates another reason, in addition to the education credits, to remove a child with income from the parents' return and let her take her own exemption.

Itemized deductions begin to be reduced at incomes of $142,700; the reduction continues as income rises until 80 percent of the benefit of the deductions is eliminated, though certain ones, such as medical expenses, are not reduced.

• 5. Marriage penalty. Like the AMT, the marriage penalty is something Congress has struggled with but not resolved. It arises when two people who have similar incomes marry. The result is that one spouse, instead of having part of her income taxed at the lowest rates, as a single earner would, sees her income simply added on top of her spouse's, so her taxes begin at whichever bracket his last dollar was in. On the other hand, couples with widely disparate incomes, or cases in which one has no income, get a marriage bonus. Congress increased the standard deduction for married couples to twice that of single taxpayers, and expanded the lower brackets so that the range for married couples is double that for singles. This reduced the marriage penalty for some lower-income couples -- and increased the bonus for others. But many upper-income couples would still be better off, tax-wise, living in sin.

-- Albert B. Crenshaw

© 2005 The Washington Post Company