What is the Alternative Minimum Tax?
The alternative minimum tax (or AMT) is an extra tax that some people have to pay on top of their regular income tax. The purpose of this tax was to prevent taxpayers with very high income from using special tax deductions and benefits to pay little or no tax. But for various reasons the AMT is affecting more and more taxpayers each year, including some people who don’t have either very high income and/or large special tax benefits. Congress is studying ways to correct this problem, but until it does, many taxpayers will be affected by this tax.
The name “Alternative Minimum Tax” comes from the way the tax works. The AMT provides an alternative set of rules for calculating your income tax. In theory the AMT calculation determines the minimum amount of tax someone with your income should be required to pay. If you’re already paying at least that amount in “regular” income tax, you don’t have to pay AMT. But if your regular tax falls below this minimum due to certain tax deductions, you have to make up the difference by paying an alternative minimum tax.
How do I know if I’m up against the AMT?
Unfortunately, there’s no easy answer to this common question, which is one of the big problems with the AMT. You can have AMT liability because of one big item on your tax return, or because of a combination of many small items. Some things that can contribute to AMT liability are normal items that appear on many tax returns, such as a deduction for state income tax or interest on a second mortgage. That’s why professional tax preparation firms like ours use sophisticated income tax return preparation software to assure ourselves and our clients we check to see if you are up against the AMT. If you want to determine on your own if you’re up against the AMT, try filling out IRS Form 6215 by hand…and good luck.
What are some of the things that cause an AMT Liability?
The following are some (but not all) of the more common items that can cause (or contribute to) an AMT liability:
Believe it or not, personal exemptions contribute to AMT liability. The exemptions you claim for yourself, your spouse and your dependents are not allowed when calculating the alternative minimum tax. It’s pretty rare (though not impossible) to see a tax return where someone had to pay AMT solely because of their exemptions, but the more exemptions you claim, the more likely it is that you’ll have AMT liability when all is said and done.
2. Standard Deduction
Some 70% of American taxpayers claim the standard deduction (rather than itemizing). The standard deduction isn’t allowed under the AMT. Usually this isn’t a problem because the AMT generally hits people with higher incomes, and these people are more likely to claim itemized deductions.
3. State and Local Taxes
If you itemize, there’s a good chance you claim a deduction for the state and local taxes you pay (such as those withheld from your paycheck), as well as real estate and property taxes. For 2004 and 2005, you can claim a deduction for sales tax if you don’t claim a deduction for state or local income tax. All of these tax deductions are not allowed under the AMT calculation. Accordingly, if you live in a place where state and local taxes are high, you’re more likely to be subject to the alternative minimum tax.
4. Interest on Second Mortgages
The AMT allows a deduction for interest on mortgage borrowings used to buy, build or improve your home. But if you borrowed against your home for some other purpose, the interest deduction isn’t allowed under the alternative minimum tax.
5. Medical Expenses
The AMT allows a medical expense deduction, but it’s limited more than the normal medical deduction under the regular income tax calculation. So, if you claim an itemized deduction for medical expenses, part or all of it will be disallowed when you calculate your alternative minimum tax.
6. Miscellaneous Itemized Deductions
Certain itemized deductions are deductible to the extent they exceed 2% of your adjusted gross income. These items here include unreimbursed employee expenses, tax preparation fees and certain investment expenses. But unfortunately these items are not deductible under the AMT calculation.
7. Various Tax Credits
Many of the tax credits allowed when you calculate your regular income tax aren’t allowed when you calculate your AMT.
8. Incentive Stock Options
Generally there’s nothing to report for regular income tax purposes when you exercise an incentive stock option. But you do have to report income related to incentive stock options for AMT.
9. Long-Term Capital Gains
Long-term capital gains receive the same preferential tax treatment under the AMT as they do under the regular income tax. In theory, they shouldn’t cause you to pay alternative minimum tax. But in practice, it’s possible to be stuck with AMT liability because of a large capital gain. The reasons are a little complicated, but mainly have to do with the fact that a large capital gain reduces or eliminates the AMT exemption amount, which is designed to protect low-income taxpayers from having to pay alternative minimum tax.
10. Tax-Exempt Interest
Interest that’s exempt from the regular income tax may or may not be exempt from the AMT. It depends on complicated rules related to tax-exempt bonds. Accordingly, bonds that aren’t exempt from AMT generally pay a slightly higher rate of interest to compensate for the fact that they aren’t fully tax-exempt. Additionally, many mutual funds invest their money in bonds that aren’t exempt under the AMT to get a higher rate of interest. Their annual statement reports how much of the exempt interest dividend you received during the year is taxable under the AMT calculation.
11. Tax Shelters
The Tax Reform Act of 1986 severely curtailed the ability to reduce income tax through tax shelters. Yet there are still some legitimate ways of reducing tax liability through investments in certain types of partnership or limited liability company arrangements involving such activities as oil and gas drilling. The AMT provides reduced tax benefits for these activities. You should always explore the alternative minimum tax consequences (among other things) before investing in a tax shelter.
If I’m up against AMT in one year, will that happen every year thereafter?
No. The AMT calculation is based on that year’s tax circumstances only. And here’s some more good news: a portion of your AMT liability — perhaps all — may reduce the tax you pay on future tax returns. The AMT credit you’re able to use in subsequent years depends on (1) how much credit is available, and (2) how much of the credit you can use.
To determine how much AMT credit is available, you have to calculate the alternative minimum tax under a different set of rules — sort of an alternative AMT. In essence you’re calculating how much of your alternative minimum tax liability came from timing items: items that allow you to delay reporting income, as opposed to items that actually reduce the amount of income or tax you report. If you’re lucky, your entire AMT will be available as a credit in future years. But some people find that only a small portion, or none at all, is available for use as a credit.
Next you have to determine how much of the credit you can use in the current year. You can only use the AMT credit in a year when you’re not paying alternative minimum tax. The amount of credit you can use is based on the difference between your regular tax and the tax calculated under the AMT rules.