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Putting the Brakes on Tax Breaks

Note: Subsequent to the publication of this article, the Congress came up with a plan to provide some relief for the Alternative Minimum Tax issues that expired at the end of 2005. You canread more about those changes.

One of the things that has made the tax code so complex in recent years has been the phasing in and out of various tax breaks. Once you think you have your tax planning figured out, the tax code pulls the rug out from under you.

So the earlier you begin planning for your 2006 taxes, the better off you'll be. And you'll need to know which provisions will no longer be in the tax code come next year. It's always possible that the folks in Congress will reinstitute some -- or all -- of the expiring provisions later this year. But since that's not a sure thing, your best bet is to assume that these breaks will not be around in 2006 and plan accordingly.

The following list of breaks set to go away is not all-inclusive, but it does include the ones that will affect the vast majority of us. All told, more than 30 provisions dealing with individuals, businesses, governments, and general tax administration are scheduled to expire.

State and local sales tax deduction
Even though this provision was available for only two years, it provided a big break for taxpayers living in the eight states that don't have a state income tax. The deduction also provided benefits to those in other states with a lower marginal tax rate or those who made a big-ticket purchase and the resulting sales tax provided a larger deduction opportunity than the amount of income tax would have. In other words, if you bought a new boat and paid $4,000 in sales tax, you could get a larger tax benefit by claiming that sales tax as a deduction if it exceeded your state income tax bill.

Combat pay and the Earned Income Tax Credit (EITC)
Previously, combat pay had been excluded from the definition of earned income, thereby reducing the earned income tax credit for some military families. But in 2004, Congress changed the rules to let military families choose whether it was to their advantage to include combat pay as earned income when calculating the EITC. Even though this provision is expiring along with tax year 2005, there's a good chance that Congress will make it permanent.

Teachers' classroom expenses
Qualified educators could deduct up to $250 in classroom expenses and didn't have to itemize their deductions to get this break. While this provision has expired, there are current proposals afoot to make it permanent, with a maximum deduction of $400. In the meantime, educators should continue to keep receipts for classroom purchases they make in 2006.

Higher-education expenses
This was another "above-the-line" item (one that didn't require you to itemize) that provided for a deduction of up to $4,000 in qualified tuition and related education expenses. Congress will probably not extend this deduction past 2005. However, the Hope and Lifetime Learning credits will remain on the books and often provide you with a larger tax benefit, anyway.

The Alternative Minimum Tax (AMT) exemption amount
This is the time bomb of all of the expiring provisions. Most taxpayers are unaware of the dreaded AMT, but with the exemption provision going away, many more will get hit with it. The AMT exemption amount -- essentially, the amount of taxable income you are allowed without triggering the AMT -- will drop back to 2000 levels for a nearly 30% decrease across the board. That means an additional 17 million taxpayers will be subject to the AMT in 2006. Congress is well aware of this potential taxpayer nightmare, but it's unwilling to make any permanent changes to the exemption amount, since the AMT does generate a large amount of tax revenue. The best that we can probably hope for is another extension later in the year. But make no mistake -- by doing nothing on this issue, Congress will be paving the way for a major tax increase for many taxpayers. So if you're not aware of the AMT, you might want to see how your projected 2006 income and deductions stack up against the new AMT exemption amounts.

Personal tax credits and the AMT
More expiring provisions will bring the AMT to bear on more taxpayers. Before 2006, virtually all of the tax credits allowable for regular tax purposes were also allowed for AMT purposes. However, beginning in 2006, certain personal credits will no longer be allowed against the AMT, including the dependent care credit, credit for the elderly and the permanently and totally disabled, the mortgage interest credit, the Hope and Lifetime Learning credits, and the D.C. first-time-homebuyer credit.

But not all of the news is bad. Next week, we'll review some of the new and phase-in provisions that will actually help the taxpayer in 2006. But in the meantime, be aware of the changes we've discussed today -- especially the AMT provision -- and how they might affect you and your 2006 tax planning.

When he's not dealing with tax issues,Roy Lewisis a motivational speaker who lives in a trailer down by the river. He understands that The Motley Fool is all about investors writing for investors. You can take a look at the stocks he owns as long as you promise not to ask him which stock to buy. He'll be glad to help you compute your gain or loss when you finally sell a stock, though.


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