Although the alternative minimum tax (AMT) was intended to apply to high-income taxpayers who take advantage of tax loopholes (called "preferences" in the tax code), it can also apply to middle-income taxpayers. In fact, studies have shown that the AMT is hitting more taxpayers every year. However, most taxpayers aren't familiar with all of the issues surrounding the AMT. That's not a good thing. Ignorance isn't necessary bliss, especially when the AMT is involved. So let's take a few minutes to see where you and the AMT might meet.
The Jobs and Growth Tax Relief Reconciliation Act of 2003 did provide for some limited AMT relief. The AMT exemption amount was increased to $40,250 (from $35,750) for unmarried filers and to $58,000 (from $49,000) for married filers. As you can see, that's just not much relief.
The characteristics most likely to give rise to AMT liability for taxpayers who do not operate businesses are large numbers of personal exemptions, large amounts of state and local taxes paid, large amounts of miscellaneous itemized deductions, large deductible medical expenses, incentive stock options, and large capital gains. So if you have any combination of these issues on your tax return, you may have the unpleasant surprise of paying the AMT.
While personal exemptions are allowed to reduce your regular tax, they are not allowed for AMT purposes. Consider the Little Old Lady that lived in the shoe. She had seven children. Those personal exemptions allowed her to reduce her regular taxable income by about $24,400 (eight personal exemptions -- seven kids and one adult -- times $3,050 each for 2003). But for AMT purposes, personal exemptions are ignored. So it's very possible that these personal exemptions, coupled with some other tax issues, could introduce her to the AMT. Living in a shoe might not be her biggest problem.
Obviously, you can't do anything about your personal exemptions. You're not going to kick your son or daughter out the door in order to reduce your personal exemptions. So there is no real way to plan your AMT issues around personal exemptions. But you might be able to plan other tax items subject to the AMT knowing that you're already at risk with a large number of personal exemptions.
State and local taxes
State, local, and other taxes paid and claimed as itemized deductions on your Itemized Deduction Schedule (Schedule A) are not allowed as a deduction for AMT purposes, and are added back to your regular taxable income for AMT purposes. And these state taxes are bringing thousands into the AMT zone -- those of you who live in high state tax states should pay particular attention. If possible, avoid paying state and local taxes in a year that you find yourself troubled with the AMT. If you pay these taxes in a year that you are hit with the AMT, they will give you absolutely no tax relief.
Say that you are subject to the AMT for 2003, but you expect to avoid the AMT in 2004. If that's the case, defer your tax payments until 2004. Be aware that deferral of these state tax payments may lead to underpayment penalties at the state or local level. But in most cases, those underpayment penalties are small potatoes compared to the tax dollars that you might save by avoiding the dreaded AMT.
On the other hand, if you expect to avoid the AMT for 2003, but you expect to be subject to it the following year, your tax payments should be accelerated into 2003 whenever possible. Just remember that the IRS will not allow a deduction for state and local income taxes unless the taxpayer reasonably believed the taxes were owed when paid. Therefore, you can accelerate the deduction for state income taxes by making estimated tax payments, but only if your reasonable computations indicate that those taxes are actually owed.
In addition, real property taxes cannot be deducted until they are actually paid to the taxing authority. Keeping that in mind, if you pay property taxes through a mortgage lender impound account, the lender's cooperation in paying the taxes before the due date may be required in order to accelerate or defer the deduction. But if you make your own property tax payments, then you have free reign as to the timing of the payments. Again, deferring those payments may lead to some penalties, but the tax savings may be well worth it.
Medical expenses may be deducted for AMT purposes, but they must exceed 10% of adjusted gross income, compared to 7.5% for regular tax purposes. Thus, as with the deduction for state and local taxes, you may be able to time medical deductions to avoid the AMT or at least obtain the maximum benefit from the deductions. Medical problems and expenses aren't something that you can usually plan. But payments for medical services are a different story. So think about the acceleration and deferral methods discussed above when dealing with medical expense payments.
Miscellaneous itemized deductions
Miscellaneous itemized deductions that are greater than 2% of your adjusted gross income are deductible for normal tax purposes. But they are not deductible for AMT purposes. These expenses include un-reimbursed employee business expenses, expenses for the production of income, tax return preparation expenses, and many others too numerous to mention here. You have a lot of control over these expenses. So if they are large, make sure to do your AMT planning so you don't lose the tax benefit of these expenses.
Large capital gains
Under the new law, capital gains are now taxed at the 15% rate. But because of the workings of the AMT, a large long-term capital gain could trigger some AMT taxes. So if you've done well with your long-term investments and are looking to liquidate, at the very least you should review your AMT consequences and determine what (if any) impact such a sale would have. If you look before you leap, you might be able to make decisions that will minimize your AMT taxes (such as selling portions of the investment over a period of two or three tax years).
Consider the little old lady above. Let's assume that for 2003 she has $75,000 in wage income, her seven dependents, and a long-term capital gain of $100,000. She'll face an AMT tax of an additional $6,380 in 2003 because of the combination of substantial gains and numerous dependents.
Incentive stock options (ISO)
If you receive ISOs from your employer, beware. The bargain element (the difference between your exercise price and the fair market value of the stock at the exercise date) is also considered a tax preference. And for many of you, this could be a very large trigger for the AMT. ISO issues are much too complicated to discuss here in any detail. Just know that if you are exercising ISOs, you potentially have big AMT issues. Make sure that you know where you stand with your AMT before you exercise your ISOs.
We'd love to give you an IRS publication that you could read about the AMT. But it seems that Uncle Sam doesn't quite understand the rules either, since there are no IRS publications dealing with the AMT. So the best that you can do is to get your hands on IRS Form 6251 and the associated instructions (Acrobat Reader required for these two links). Then play with the form to see how the AMT might impact your specific tax situation. Don't be surprised by the AMT. It's worse than the bogeyman!
Roy Lewis lives in a trailer down by the river and is a motivational speaker when not dealing with tax issues, and he understands that The Motley Fool is all about investors writing for investors. You can take a look at the stocks he owns as long as you promise not to ask him which stock to buy. He'll be glad to help you compute your gain or loss when you finally sell a stock, though.