This is a very often misunderstood part of the tax code, and it seems like my clients understand it better than the people that continue to vote for it in Washington. The bottom line is that it should be repealed, but alas, it has not been, so we will have to deal with it for now.
The easiest way to understand AMT is to try and remember the items that trigger it. The list below are the most common triggers, and it is not 100% complete – there are other items that can contribute to AMT liability. Based on my experience, the items described below are likely to affect more people than other items. For a complete list, see IRS Form 6251 and its instructions.
From a practical standpoint, and most disheartening, is that I often see people making certain moves thinking they are getting a tax benefit, only to learn later that what they are doing is triggering AMT, and thus, the tax benefit is nullified. Always make sure you understand your AMT situation before assuming that any sort of tax move will actually save you taxes.
The “Major” Culprits
IRS statistics indicate that two items are far more important than any others in triggering AMT. These are not the kind of special tax benefits that provided the motivation to create the AMT, but Congress designed the tax to exclude these benefits, and still, they’ve become the main generators of AMT liability. Again, most of Washington agrees this needs to be changed, but they just haven’t gotten around to it yet, since only a very small fraction or voters actually care about it.
- State and local taxes. If you itemize, there’s a good chance you claim a deduction for state and local tax, including income tax or sales tax and, if you own a home, property tax. These deductions are not allowed under the AMT. If you live in a place where state and local taxes are high, you’re more likely to be subject to AMT.
- Personal exemptions. Here’s one that will leave you scratching your head – personal exemptions contribute to AMT liability! The exemptions you claim for yourself, your spouse and your dependents are not allowed when calculating AMT. 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.
Here are some of the ways you may encounter AMT from investment activity:
- Long-term capital gains. These gains (and qualified dividends) receive the same preferential rate under the AMT as they do under the regular income tax. In theory, they shouldn’t cause you to pay AMT. In practice, it’s possible to be stuck with AMT 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.
- Tax-exempt interest. Interest that is exempt from the regular income tax may or may not be exempt from the AMT. The distinction depends on complicated rules that are fully understood only by bond lawyers. Bonds that aren’t exempt from AMT (the IRS calls them specified private activity bonds) pay a slightly higher rate of interest to compensate for the fact that they aren’t fully tax-exempt. If you invest in bonds that aren’t exempt under the alternative minimum tax, you’ll see an entry for this item on Form 1099-INT. Many mutual funds that provide exempt interest invest at least some of their money in bonds that aren’t exempt under the AMT, to get a higher rate of interest. In this case you’ll see an entry for this item on Form 1099-DIV.
- Tax shelters. The Tax Reform Act of 1986 – the same law that created the current version of the AMT – severely curtailed opportunities 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 restricts the tax benefits you can claim based on these investments. You should always explore the AMT consequences (among other issues) before investing in a tax shelter.
Incentive Stock Options
Generally you don’t report anything on your regular income tax at the time you exercise an incentive stock option. But you have to report income for purposes of the AMT. Exercising a large incentive stock option is almost certain to cause you to pay alternative minimum tax unless you sell the stock within the same year.
- Interest on second mortgages. The AMT allows a deduction for interest on mortgage borrowings used to buy, build or improve your home. If you borrowed against your home for some other purpose, the interest deduction isn’t allowed under the alternative minimum tax.
- Medical expenses. The AMT allows a medical expense deduction, but it may be smaller than the deduction under the regular income tax. If you claim an itemized deduction for medical expenses, part or all of it may be disallowed when you calculate your alternative minimum tax.
- Standard deduction. Some 70% of U.S. 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. Yet it’s worth noting that a deduction that’s so widely used can contribute to AMT liability.
- Miscellaneous itemized deductions. Certain itemized deductions are available if your total deductions in this general category add up to more than 2% of your adjusted gross income. Among the items here are unreimbursed employee expenses, tax preparation fees and many investment expenses. You can’t deduct these items under the AMT, though. A large deduction in this category could lead you to pay alternative minimum tax.
- Certain credits. Some of the credits used to reduce regular income tax are limited or disallowed in the AMT calculation. However, credits known as “personal credits,” which include the most common ones claimed by individuals, are permitted.