AMT Capital Gains Glitch Fixed

If you were caught by this odd glitch in the tax law, you may be able to file for a refund.

Imagine that you prepared your tax return and were ready to file when you realized you forgot to claim a deduction for one of your state or local tax payments. So you change the numbers on your tax return to include the additional deduction, and find that your tax is now higher than it was without that deduction. You must have made a mistake, right?
    No, Congress made a mistake. There was a glitch in the way capital gains are treated under the AMT, and they fixed it in the Working Families Tax Relief Act of 2004. The fix is retroactive, and this means you can apply for a refund if you paid additional tax because of this problem during any year that's recent enough for an amended return. Generally that means returns filed in the last three years, so as of this time (October 2004) most people who are affected can get refunds for 2001, 2002 and 2003. If you filed your 2000 return on October 15, 2001, you can still get a refund for that year also, but you'll have to hurry.
    Only a small number of taxpayers are affected, but some of them are entitled to refunds of thousands of dollars. To be a candidate for this refund, you had to have long-term capital gain, and in the same year, either

• pay alternative minimum tax (AMT), or
• claim AMT credit, without being able to claim all your available AMT credit.

Even then you aren't necessarily affected. If your regular taxable income, including deductions, was large enough to put you in a tax bracket higher than the 15% bracket, this error in the tax law didn't increase your tax. The level of taxable income where you'll be affected depends on your filing status and which tax year we're talking about. For 2003, the problem potentially affects singles with taxable income below $28,400 and couples with taxable income below $56,800. Remember, though, these numbers refer to taxable income, after you've claimed your exemptions and all other deductions. You can be affected even if you have a great deal of income, provided that you also have sizeable deductions.

What's the problem?

The problem has to do with determining the amount of long-term capital gain that qualifies for the 5% rate (rather than the 15% rate) under the AMT. Congress intended to allow the 5% rate under the AMT to the same extent you would get it under the regular income tax. In a drafting error, the law says you get the 5% rate only to the extent you actually get that rate under the regular income tax. That can make a big difference.

Example: You and your spouse file jointly and have no dependents. For 2003 your joint return shows $32,100 of salary, $82,000 of long-term capital gain and $73,000 of itemized deductions that aren't allowed under the AMT. Under the regular income tax, your taxable income is $35,000 (salary and capital gain reduced by the itemized deductions and $6,100 for personal exemptions). The deductions count first against your salary income, so all your income is taxed as capital gain. You're allowed to use the 5% rate for long-term capital gain that falls below the taxable income level of $56,800, so the entire $35,000 is taxed at 5%, for a regular income tax of $1,750.
    Under the AMT, you aren't allowed to claim these deductions. After claiming the AMT exemption amount, you have $56,100 of income. Once again it is all capital gain, and it should all be taxed at the 5% rate because it's below the $56,800 threshold established by the end of the 15% tax bracket. But only $35,000 of your capital gain was actually taxed at the 5% rate under the regular income tax, so the poorly written law required you to pay the 15% rate, instead of the 5% rate, on all your capital gain above $35,000. You end up paying an extra 10% on over $20,000 of capital gain, so this mistake in the law costs you over $2,000.

The new (October 2004) law fixes the problem. If your situation happens to match the one in this example, you can apply for a refund of more than $2,000.
    The problem isn't a common one because relatively few taxpayers with taxable income below the top of the 15% tax bracket encounter alternative minimum tax. Yet if you have unusually high deductions for items like state and local taxes (including property tax) and/or a large number of personal exemptions, you could have been hit with added tax on your long-term capital gains because of this rule.

What to Do

Unfortunately, we don't have tax forms that tell us how to calculate the correct amount of tax. Form 6251, used for alternative minimum tax, requires you to use the calculation set forth in the old law. The IRS will fix this for the 2004 tax forms, of course, but it remains to be seen whether they will create new versions of this form for earlier years, to make it easier for the affected taxpayers to apply for refunds.
    As a result, it probably makes sense to wait until we have further guidance from the IRS before trying to obtain this refund. Make sure you check your eligibility for the 2001 tax year by April 15, 2005, though. After that, it may be too late to claim your refund.
    The only exception would be people who are about to lose the ability to claim a refund for the year 2000, because they filed on October 15, 2001. Those people should see a tax pro right away if it appears this law may entitle them to a refund. You can put in a refund claim now and worry later about fixing up the paperwork if the IRS wants you to use a particular form for the calculation.