AMT reform: The cap gain conundrum

NEW YORK (CNNmoney.com) -- Under the Alternative Minimum Tax (AMT), you're not allowed to take a lot of the income tax breaks you might otherwise enjoy under the regular income tax code. But there is one that's preserved: The reduced 15 percent rate on capital gains and dividends.

Capital gains used to be taxed more heavily under the AMT, and one leading tax expert says doing so again could help lawmakers offset the revenue lost if they choose to reform AMT and refocus the tax on its original target -- the very wealthy few who shelter a lot of money from taxes.

"If the purpose of AMT is to limit tax shelters, this makes sense since virtually any individual income tax shelter you can imagine involves converting ordinary income into lightly taxed capital gains or dividends," said Len Burman, director of the Tax Policy Center, during testimony before a House panel last week.

If lawmakers do nothing, the AMT will impose a higher tax bill on tens of millions of otherwise middle-class taxpayers because, among other things, its key income parameters were never adjusted for inflation.

Reforming the AMT is estimated to reduce federal revenue by roughly $500 billion if the tax cuts are allowed to expire in 2010 and up to $1.2 trillion if the cuts are made permanent. That's because extending the cuts lowers tax bills under the regular code, which exposes more people to AMT and yields more tax revenue for the government

Burman has laid out several reform options that could shield the middle class from the tax and make up for the revenue lost as a result, a few of which would tax capital gains more heavily than they are currently.

In one scenario, AMT reform could be paid for if lawmakers taxed capital gains at the AMT rates of 26 percent and 28 percent and increased the top three income tax rates under the regular code by about 0.8 percentage points each in 2007 and again in 2011.

That assumes the tax cuts of 2001 and 2003 expire, in which case the top three income tax rates under the regular code are already expected to revert to their higher, pre-2001 levels. So by 2011, under Burman's scenario, the top three rates would be 31.7 percent, 36.8 percent and 40.4 percent, up from 28 percent, 33 percent and 35 percent currently.

In another scenario, capital gains would be subject to AMT rates but instead of increasing the top three regular income tax rates, lawmakers could raise the AMT rates instead to 26.8 percent and 28.9 percent.

How politically viable a capital gain and dividend tax increase under the AMT would be is a big question mark given how adamant the Bush administration and other lawmakers have been about preserving the capital gains cut, and how many lawmakers on both sides of the aisle believe there needs to be incentives to encourage investment.

Clint Stretch, managing principal of tax policy at Deloitte Tax LLP, thinks it's not likely that lawmakers would opt to hike the tax rate on capital gains from 15 percent to as high as 26 percent and 28 percent as Burman maps out. "But there's every percentage point in between," Stretch said, noting that raising the capital gains rate somewhere between 16 percent and 20 percent might be achievable.

"This is a very dicey conversation. There are questions of who bears the burden," he noted. "If you shift this burden to high-income people you have to look at investment income because that's the income they have."

If outright rate hikes prove unpalatable, you may see capital gains tax increases for AMT taxpayers that don't change rates explicitly, Stretch suggested.

For example, he said, lawmakers might opt for a capital gains exclusion -- i.e., a portion of your capital gains would be excluded from taxes and you'd owe income tax on the rest. And that exclusion would be smaller under the AMT than it would be under the regular income tax code, increasing the effective tax rate AMT taxpayers will pay relative to what they would pay today.

"You've got to find some way to put a fig leaf in front of this, because no one wants to have higher taxes," said Stretch.

So, for example, say there's a 50 percent exclusion under the regular income tax code. The effective capital gains tax rate for someone in the 28 percent bracket would be 14 percent, less than the current 15 percent rate. (For every $100 in capital gains, you'd only pay tax on $50 at 28 percent, which is $14.)

But under the AMT, maybe you'd only only be allowed to exclude 40 percent of your gains. The effective tax rate for someone whose top AMT rate is 28 percent would be 16.8 percent. (For every $100 in capital gains, you'd pay tax on $60 at 28 percent, which is $16.80.)

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