Although the alternative minimum tax (AMT) was intended to apply to high-income taxpayers who take advantage of loopholes (called "tax preferences" in professional lingo), it can also apply to middle-income taxpayers who haven't planned their taxes thoroughly enough. In fact, the AMT is hitting more and more taxpayers each year, and without annual patches, it would increase taxes on millions of taxpayers.
You're probably not familiar with all of the issues surrounding the AMT -- but in this case, ignorance isn't necessarily bliss. Let's take a few minutes to see where you and the AMT might meet.
The characteristics most likely to give rise to AMT liability for "ordinary" taxpayers who do not operate businesses are:
- A large number of personal exemptions.
- A large amount of state and local taxes paid.
- A large amount of miscellaneous itemized deductions.
- A large amount of deductible medical expenses.
- The bargain element of incentive stock options.
- A large amount of capital gains.
If you have any of these issues on your tax return, or any combination of them, you could have the unpleasant obligation 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 who lived in a shoe, of nursery-rhyme fame. She had seven children, so between herself and her kids, those personal exemptions allowed her to reduce her regular taxable income by about $27,200 -- eight personal exemptions at $3,400 each -- in 2007.
But for AMT purposes, personal exemptions are ignored. It's possible that these personal exemptions, coupled with some other tax issues, could introduce that little old lady to the AMT. Living in a shoe might not be her biggest problem.
There's no real way to "plan" your personal exemptions for AMT purposes. After all, you're obviously not going to kick a son or daughter out the door to reduce your personal exemptions. But you might be able to plan other tax items that could trigger the AMT, if you know that your significant personal exemptions already put you at risk.
State and local taxes
State, local, and other taxes that you pay and claim as itemized deductions on Schedule A are not allowed as deductions for AMT purposes. If possible, you should try to pay state and local taxes in years when you won't face the AMT; otherwise, they'll give you absolutely no tax relief. Whenever possible, know when you're in the AMT zone, and do your best to move these tax payments to another year when the AMT won't bother you.
Suppose that you're subject to the AMT this year, but you expect to avoid it next year. You should try to defer your state and local tax payments until next year. Doing so might lead to underpayment penalties at the state or local level, but in most cases, those underpayment penalties are small potatoes compared with the potential tax dollars you might save.
Likewise, if you expect to be subject to only the regular tax for this year, and the AMT the following year, your tax payments should be accelerated into this year whenever possible. Just remember that the IRS will not allow a deduction for state and local income taxes unless the taxpayer reasonably believes the taxes were owed when paid. Therefore, you can accelerate your 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. If you pay property taxes through a mortgage lender, you'll need the lender's cooperation in paying the taxes before the due date if you want to accelerate or defer the deduction. But if you make your own property-tax payments, you have free rein regarding the timing of the payments. Again, deferring those payments might lead to some penalties, but the tax savings could be well worth it.
Medical expenses can be deducted for AMT purposes, but they must exceed 10% of adjusted gross income, instead of 7.5% for regular tax purposes. Thus, as with the deduction for state and local taxes, you might be able to time medical deductions to avoid the AMT, or at least obtain the maximum benefit from the deductions. Again, medical problems and expenses aren't something you can usually plan, but you do have a bit of control over when you pay medical bills. So think about the acceleration and deferral methods that we discussed here 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 unreimbursed employee business expenses, expenses for the production of income, tax-return preparation expenses, and many others too numerous to mention here. Unlike with the previous items, you do have much more control over these expenses. If you know they'll be large, make sure to do your AMT planning so you don't lose the tax benefit of these expenses.
Large capital gains
You might have heard that the lower tax rates for capital gains will not trigger the dreaded AMT. That's only partially true. For AMT purposes, you'll also receive a lower rate on long-term capital gains. 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, you should at the very least review your AMT consequences and determine what (if any) impact such a sale would have. If you look before you leap, you can potentially take steps to minimize your AMT taxes -- for example, by selling only part of the investment in each of two or three tax years.
Incentive stock options (ISOs)
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 on the exercise date -- is considered a tax preference for AMT purposes. Although you'll owe no regular tax on this bargain element, it could certainly trigger the AMT. 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're exercising ISOs, you have potentially big AMT issues.
The IRS has no official publication on the AMT, but it does provide an online worksheet that might help with your AMT planning. As of now, the worksheet hasn't been updated for the 2007 tax year, but you can enter your information in the existing worksheet, find out how close you might be to getting smacked by the AMT, and even play some "what if" games for future planning purposes. Spend a few minutes with the worksheet to see how the AMT might affect your specific tax situation going forward.