Making Sense of a Complicated Tax
The AMT, or Alternative Minimum Tax, is one of the most vexing and complicated areas of tax laws. Many taxpayers who anticipate being able to deduct certain expenses or to take advantage of certain tax advantages are surprised to find themselves unable to do so because they have been penalized by the AMT, which was created almost 50 years ago for the specific purpose of making sure that higher-income individuals were unable to avoid paying taxes. However well-intentioned the Alternative Minimum Tax may originally have been, as a result of years of inflation it has come to impact an increasing number of taxpayers that it was not originally designed to address.
The AMT is considered a punitive tax computation. For those who fall under its guidelines, previously-available deductions and advantages are eliminated and are replaced by higher tax liabilities. How can you tell whether you have been affected by the Alternative Minimum Tax? The simplest way is to prepare your tax return and see whether the calculation has resulted in an amount needing to be entered on line 45 of the return. If your income and expenses have triggered the AMT, then the higher tax amount that you owe will appear on that line.
How Does the AMT get Triggered?
Many taxpayers are surprised to find that they qualify for the AMT, but there are a number of factors that can trigger it. Some of these are individual elements that automatically make the AMT kick in, while in other times the tax is only activated as a result of a combination of deductions being taken. Though each taxpayer’s situation is different, some of the items that most commonly cause the Alternative Minimum Tax to be applicable include:
Taking Deductions for Medical Expenses – In order to take deductions for medical expenses, a taxpayer is required to spend an amount that is more than 10 percent of their income. Though these deductions are permitted according to the rules of the Alternative Minimum Tax, through the year 2016 taxpayers who are 65 or older who have incurred medical expenses that total just 7.5 percent of their income are entitled to a deduction – but it will trigger the AMT. In order to avoid this punitive calculation, tax professionals often advise clients to either accelerate paying medical expenses to a year in which the AMT would not be triggered, or to defer making payments. One of the most common examples of how to defer a large payment is by making payments on an installation basis, such as may be done for a child’s orthodontia. Another way to avoid triggering the AMT with medical expenses it to take advantage of your employer’s flexible spending plan benefit. This provides the ability to use pretax dollars for the payment of medical bills without having those bills trigger any deduction limits.
Taking Deductions for Taxes that You’ve Paid – Many taxpayers who itemize take deductions for state income tax, sales tax, and tax that they have paid on real or personal property. These taxes often represent the most valuable deductions that taxpayers receive – but they also are the ones that most frequently activate the Alternative Minimum Tax. The best way to avoid losing the ability to take advantage of these deductions is to defer paying these taxes to another year, but it is important that doing so does not make you liable for interest payments, penalties or other negative repercussions for not paying in a timely manner. Another option for those who have paid taxes on unproductive or unimproved real estate is to forego the deduction and instead to capitalize the taxes paid by adding them to the property’s real cost basis.
Taking Deductions for Home Mortgage Interest – Taxpayers are able to deduct the interest that they pay on loans that help them to purchase first or second homes. They are also able to deduct the interest on loans that help to pay for improvements. The caveat to this rule is that the debt falls under the existing limit, which is usually around $1 million. Taking advantage of this deduction for either a loan or a refinance of a loan will not trigger the AMT with one exception. Debt incurred as a refinance counts as equity debt, and is subject to different limitations. If you are not subject to the AMT, then you can deduct the interest on up to $100,000 of equity debt on your first two homes. If, however, you are subject to the AMT, you may not take this deduction. You are also not able to take a deduction on equity debt or acquisition debt if your second home is either a boat or a motor home. It is a mistake to rely upon loan brokers for tax advice regarding home equity debt, as they are frequently unaware of the complexities of the AMT and how it may affect you.
Taking Deductions for Miscellaneous Items – There are many deductions that the IRS categorizes as “miscellaneous”. These can include employee business and investment expenses. Those who fall into the AMT category are not able to take these deductions, and it is often those expenses that will trigger the AMT. If you are an employee who incurs these types of expenses to a significant degree, it is probably a good idea to discuss the situation with your employer to see whether you can be provided with what is known as an “accountable” reimbursement plan. This would allow you to be reimbursed for your qualified expenses on a tax-free basis, while eliminating the need to take a deduction. Failing this, it is recommended that you wait until a year that would not be impacted by the AMT to take those deductions.
Taking Deductions for Personal Exemptions – For tax year 2016, each taxpayer is entitled to take a personal exemption of $4,050 for themselves, their spouse, and any dependents they may have. However, if you qualify for the AMT you are not permitted to take this deduction. If you are a parent who is either divorced or separated, it is a good idea to discuss how the AMT impacts each parent in order to determine who is best able to claim a deduction for the children.
Taking the Standard Deduction – Every taxpayer has the choice of taking the standard deduction or itemizing, but if you qualify for the AMT you are not able to take advantage of the standard deduction. As a result, if you find yourself impacted by the AMT, it is highly recommended that you itemize aggressively, regardless of whether doing so results in a deduction that is lower than what you would have received for taking the standard deduction. This may seem counterintuitive because it would result in a higher regular tax – but because it lowers the AMT it may end up saving you more in the end. This is because being taxed at the lowest bracket for the AMT, which is 26%, can yield a bigger tax deduction benefit.
Taking Deductions for Incentive Stock Options – For taxpayers who are provided with incentive stock options (ISOs), there are several ways to avoid being penalized by the AMT. The benefit of having an ISO lies in the capital gains that are achieved by holding onto it for more than a year between the time that it is exercised and the time that the option is granted, but doing so triggers the AMT. One of the best ways to avoid this result is to sacrifice the long-term benefits and sell the stock in the year that it is exercised. An alternative to this is to exercise the option over time instead of all at once.
Taking Deductions for Business Incentives – Investing in partnerships and businesses can result in a number of tax incentives, including such deductibles as intangible drill costs and depletion allowances, but unfortunately the AMT often cancels out these advantages.
This list of deductions that trigger the AMT is not inclusive – there are many other items that can have the same impact. If you are uncertain as to what action to take in order to avoid triggering the AMT, contact our office to set up a consultation.
If you have questions about any of this, or the tax impact of any other advanced planning, call our office today at (562) 445-3888.