Alternate Minimum Tax or AMT is a parallel tax system designed by Congress to force people who take various large deductions in order to avoid taxes, to pay some minimum tax. AMT eliminates many deductions and credits, thus increasing tax liability for an individual who would otherwise pay less taxes. AMT excludes various items such as 401(k), 403(b) salary deferrals, accident insurance proceeds, child support, gifts received, group term life insurance, etc. The AMT is no longer an issue for rich people. More and more people falling in middle class are getting hit by AMT. The Treasury Department is projecting the percentage of married couples with children earning between $100,000 and $200,000 paying AMT to be around 35 percent.
To figure out whether you owe any additional tax under the Alternative Minimum Tax system, you need to fill out Form 6251. If the tax calculated on Form 6251 is higher than that calculated on your regular tax return, you have to pay the difference as AMT.
How to calculate AMT?
There are essentially 3 steps in calculating AMT. First you determine your taxable income for regular tax purposes. Second, you determine two important items: AMT Adjustments and AMT Preferences. Lastly, you simply add adjustments and preferences to regular taxable income. If this amount is more than the AMT exemption for your tax status then you have AMT tax liability. Usually, AMT adjustment for a given year is declared during November-December period of that year. For the current year, AMT has the exemption of $52,800 for singles, $82,100 for married filing jointly, and $41,050 for married filing separately.
AMT adjustments are the expense items that are added back to regular taxable income. Here is a list of such adjustments:
- Personal Exemptions: Not allowed. So all personal exemptions combined is an adjustment.
- Standard Deduction: Not allowed. So the standard deduction that you are qualified for is an adjustment.
- Itemized Deduction: Most of itemized deduction is allowed under AMT. Those which are excluded form an adjustment.
- Medical Expenses: Medical expenses greater than 7.5% of AGI are deductible under regular tax. But under AMT, medical expenses over 10% of AGI are allowed. As a result, the difference between the two is an adjustment item.
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- Depreciation of personal property in business use: Under regular tax system, you can use accelerated depreciation (MACR) to get a higher tax deduction sooner. But AMT system allows only average depreciation schedule (ADS) e.g. 20% depreciation each year with a useful life of equipment equal to 5 years.
- Incentive Stock Options (ISO): When you exercise ISOs, meaning you pay the cost of acquiring stock but do not sell the stock in the year of exercise, under regular tax system it is not a taxable activity. But under AMT, the difference between the option award or exercise price and market price of the stock on the day of exercise is an AMT adjustment item. This had a devastating impact for some people technology sector who got ISOs granted at a very low price and who exercised them during internet boom of 1999-2000 and were left holding a huge tax liability during the quick burst when these securities quickly become nearly worthless.
- Miscellaneous Itemized Deductions Over 2% of AGI: They are allowed under regular tax system but not under AMT. So, any deduction taken for this under regular tax is an AMT adjustment that needs to be added back.
- Home Equity Interest: Home mortgage interest claimed as an itemized deduction is only deductible for the AMT if the loan was used to buy, build or improve your home. For regular tax purposes, interest on home equity mortgages up to $100,000 is deductible, even if the proceeds are used for personal purposes, such as buying a car.
AMT preference items are generally less common. They include:
- State income tax
- Percentage depletion in excess of adjusted cost basis on personal property in business use
- Interest on certain private activity bonds (sports arena) and income from municipal bonds. These items are generally exempt from regular taxes but not from AMT.
- Intangible drilling costs
You need to recognize that the AMT is not a simple add-on tax that is calculated independently of other taxes on the return. Many strategies that reduce or eliminate AMT do so by increasing the regular tax. So, reducing the overall tax liability is not a good approach. Here are a few ideas on this topic.
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- Instead of reducing overall taxes, reducing AMT adjustment items makes more sense. The biggest of these are normally state income taxes and local real estate taxes. If these taxes are higher, you may consider pushing the last real estate tax payment or state estimated taxes into the upcoming year. In the year you have to pay the AMT, avoid prepaying real estate or fourth-quarter state estimated tax payments in December. You will get no benefit from paying these taxes in a year that you are subject to the AMT.
- Elect to itemize your deductions only if it reduces your total tax, not merely because the AMT component decreases.
- Another way to avoid AMT liability is to stay out of the $150,000 to $400,000 income range. This is not to suggest that you should earn less. It has more to do with income associated with things like capital gains. For example, it might be better to realize a $500,000 capital gain all in one year rather than dividing it into two or three years.
- If you are subject to the AMT, there is no advantage in using a home equity line of credit to make a major purchase e.g. a car. The reason being, unlike in regular tax, the interest on home equity line is not deductible under AMT.
- If your employer has a pre-tax medical deduction plan or a cafeteria plan, it is beneficial to join it from AMT perspective. This helps you reduce your salary to pay for medical expenses on a pre-tax basis. This will also help you reduce both the AMT and regular tax because it is an above the line deduction.
- Real estate tax and personal property taxes are not deductible for AMT if they are part of itemized deductions.
- In case of ISOs, if after exercising the options when the market price is high, if the stock falls before the end of the current year, you can sell the stock and avoid the AMT.
Here's an illustration using capital gain as an example. In case of a regular income tax, for every $1,000 of long-term capital gain, your regular income tax goes up by $150 (using a flat 15% long term capital gains tax rate). When we move over to the AMT, the same $1,000 is taxed at 15%, but in addition, it also eliminates $250 of your exemption amount, (exemption is phased out at a rate of 25%). The exemption amount is used to reduce the amount of taxable income. So your tax under the AMT rules goes up by about $70, which is 28% of this added $250. In effect, you're paying 22% on the capital gain under the AMT and 15% on the gain under the regular income tax. So, a big capital gain can lead to a big AMT bill. Lately, almost a third of Americans are becoming victim of the AMT. Congress is looking into changing this over a decade old law. Check the IRS website http://apps.irs.gov/app/amt/ to determine if you are likely to be a candidate for AMT.
