AMT Surprises Many Taxpayers
Are you familiar with the Alternative Minimum Tax? It’s the bane of many an American taxpayer’s existence – an add-on methodology to the tax code that requires income tax calculations to include an additional look that can end up taking away tax advantages and deductions. The IRS requires that the special Alternative Minimum Tax calculation be done, and if the results yield a higher tax amount owed when it’s used, then that’s what you have to pay.
How can you tell if you are required to pay Alternative Minimum Tax? It all comes down to your entries on your income tax return and whether you end up having an amount entered on line 45. If you do, then that means you fall prey to this punishing loss of tax advantages, and lose your ability to simply file using the normal calculation.
The Origin of the AMT
It’s been almost fifty years since the creation of the AMT, a tax specifically created to level the playing field and stop high earners from legally getting out of paying taxes through careful use of deductions and exemptions, referred to as preferences. Though this was the original intention, as incomes have increased as a result of inflation, the tax has impacted a much larger percentage of taxpayers, far beyond its original goals.
Predicting or determining who will end up having to pay the AMT is complex, as there are many factors that can trigger it, but the list below includes a number of deductions and exemptions that generally put it into action:
- Itemizing taxes paid – Americans are subject to a number of taxes, and are permitted to deduct some of them. But if you take a deduction for real or personal property taxes, or state income tax or sales taxes, there is a good chance that doing so will place you squarely into AMT territory.
Losing the ability to deduct taxes paid is a painful proposition, as for many it is one of the biggest deductions available to them. There are a number of options available to avoid the AMT and still take this deduction, including deferring tax payments to a year in the future so that the AMT doesn’t apply for the current year, but this runs the risk of facing penalties and fees from the local tax authority. There is also the possibility of sacrificing the deduction entirely and choosing instead to capitalize the tax paid on unproductive or unimproved real estate – this adds the amount paid in taxes to the real property’s tax basis.
- Deductions for medical expenses – Medical expenses are notoriously difficult to tax deductions for, as there is a requirement that they exceed 10% in order to be exempt – an amount that only a relatively small percentage of the population spend. For those that do incur these high expenses, the AMT does allow them to be included in the computation. If you are 65 or older the threshold adjusts to 7.5% for both regular taxes and AMT, and there is also the possibility of avoiding the impact entirely by spreading out payments over time, accelerating payments, or paying for expenses through an employer’s flexible spending plan, which allows such expenses to avoid these limitations by paying with pretax dollars.
- Deductions for home mortgage interest – This is one of the most popular and frequently taken deductions, and it can be taken by those subject to the AMT calculation as well as those paying regular taxes. The deductions are available on interest paid on debt for first or second home acquisitions and improvements, and can also be taken on debt that is refinanced. If you take on more debt than you originally carried, it is treated as equity det, and any debt over the $1 million threshold is not eligible.
Taxpayers who are not required to use the AMT calculation are able to deduct interest on equity debt up to $100,000 on both first and second homes, but neither equity debt nor acquisition or equity debt on a boat or motor home are available for those who are subject to the AMT calculation. Those who are subject to the AMT calculation should bear these restrictions in mind if they are considering increasing their debt load on their home, as it is unlikely that they will be notified of this by those with whom they are taking out their loans.
- Personal Exemptions – Though in 2016 regular taxpayers are permitted to take a personal deduction of $4,050 each for themselves, their spouse, and any dependents they may have, this exemption is not available for those required to use the AMT computation. When a couple is divorced or separated with children and one is subject to the AMT, the parents should be strategic in their decision as to who should take an exemption for their children.
- Standard Exemption – The standard deduction is an option available to those who are determining their taxes due using the standard calculation – they may choose to either take the deduction or itemize. This is not a decision facing those subject to the AMT, as they are not permitted to take the standard deduction. In practice what this means is that if it is determined that you are subject to the AMT, you should exercise every exemption to which you may possibly be eligible.
Doing so will have the effect of increasing the amount of taxes that you owe, but at the same time will lower your AMT, and the end result could be that you end up saving on the amount of taxes that you owe. The goal is to lower your tax bracket, and adding on deductions may be an effective method of achieving that.
- Business Incentives – The AMT does not permit taxpayers to take advantage of the various tax benefits offered to those who invest in businesses and partnerships. These incentives, which would otherwise be listed on a Schedule K-1, and which may include such things as intangible drill costs or depletion allowances, have to be included in the AMT calculation.
- Incentive Stock Options – The incentives for stock options, referred to as ISOs, are uncommon, but for those who receive them they can have a dramatic effect on a taxpayer’s tax status, and on whether they are subject to the AMT. There are beneficial long term capital gains rates that the owners of stock can realize if they have held onto a stock for a year past having exercised their option and two years after the option is granted, but this benefit – the difference between the option price and the fair market value – is unfortunately calculated as income for the year the option was exercised under the AMT rules.
There are a number of ways to avoid this penalty, including selling the stock in the same calendar year that the option is exercised. The taxpayer would have to sacrifice the benefit of their long-term capital gains rates. Another way around the AMT in this situation is to forego exercising the option all at once, and instead breaking down the sale over a period of years in small incremental amounts.
- Miscellaneous Itemized Deductions – There are number of deductions that are classified as miscellaneous, including employee business and investment expenses. Unfortunately, trying to take advantage of employee business expense deductions generally triggers the requirement to use the AMT calculation, so those who incur a lot of these types of expenses related to their job are advised to discuss the issue with their employer.
Using what is referred to as an “accountable” reimbursement plan can alleviate the AMT burden, making any reimbursement received for qualified expenses tax free and therefore eliminating the need to take the triggering deduction. Employees can also give consideration to waiting to take the deduction for the expense on a year when the AMT does not come into play.
Fully understanding the AMT and all of its ramifications requires years of experience and study, as it is extremely complex.
If you would like professional assistance in trying to minimize its negative impact on your tax rate, contact our office today at (770) 268-3434 to set up an appointment.