Blog

The alternative minimum tax, originally created to curb tax shelters and tax preferences of the wealthy, can now apply to the average taxpayer. Six commonly encountered deductions routinely cause the average taxpayer to be hit by the AMT. Incentive stock options can also have a profound impact on the AMT.

There are two ways to determine your federal tax liability - the regular way that most everyone understands, and the alternative minimum tax method. Your tax will be the higher of the two.

So what is the alternative minimum tax and why are you getting hit with it? Well, many, many years ago, Congress, in an effort to curb tax shelters and tax preferences of wealthy taxpayers, created an alternative way of computing tax that disallows certain tax deductions and preferences, and called it the alternative minimum tax. Although originally intended to apply to the wealthy, years of inflation caused more and more taxpayers to be caught up in the tax. It now no longer just affects wealthy taxpayers and can apply to almost any taxpayer if the conditions are correct. Congress has been discussing AMT reform for years but has failed to take any action.

Depending on the amount of your “taxable excess,” AMT basically taxes you starting at either the 26% or 28% federal rate while the regular tax brackets start at 10% then it increases to 15% and then to 28%, 33%, 35% & 39.6%.

The list of tax deductions and preferences not allowed when computing the AMT is substantial and at times complicated. However, the following six items routinely cause the average taxpayer to be hit by the AMT:

1. Medical Deductions – Prior to 2013, medical deductions were allowed to the extent they exceeded 7.5% of a taxpayer’s income for regular tax purposes and 10% for the AMT computation. However that difference, except for the elderly, has been eliminated now that the Affordable Care Act raised the 7.5% to 10% for regular tax, making it the same as for the AMT. For taxpayers aged 65 and older, the regular tax adjustment remains at 7.5% through 2016, and that creates a medical AMT adjustment for seniors affected by the AMT.

2. Tax Deductions – When itemizing deductions, a taxpayer is allowed to deduct a variety of taxes, including real property, personal property and state income tax. But for AMT purposes, none of the itemized taxes are deductible. For most taxpayers, this represents one of their largest tax deductions, and frequently triggers the AMT. If you are affected by the AMT, conventional wisdom would dictate deferring tax payments to a subsequent year when the AMT may not apply. When deferring, care should be exercised with regard to late payment penalties and interest on underpayments for certain taxes. In addition, taxpayers can annually elect to capitalize taxes on unimproved and unproductive real estate. This means foregoing the deduction currently and adding the tax paid to the cost basis of the real property which decreases future gains.

3. Home Mortgage Interest – For both the regular tax and AMT computations, interest paid on a debt to acquire or substantially improve a main home or second home is deductible as long as the debt limit (generally $1 million) isn’t exceeded. This is true of refinanced debt, except that any increase in debt is treated as equity debt. For regular tax purposes, the interest on up to $100,000 of equity debt on the two homes can also be deducted. However, equity debt is not deductible against the AMT; neither is the acquisition or equity debt interest on a motor home or boat that qualifies as a second home. Therefore, taxpayers should exercise caution when incurring home equity debt. Generally, loan brokers are not aware of these limitations, and there are numerous pitfalls.

4. Miscellaneous Itemized Deductions – The category of miscellaneous deductions, which includes employee business expenses and investment expenses, is not deductible for AMT purposes. For certain taxpayers with deductible employee business expenses, this can create a significant AMT. Employees with significant employee business expenses should attempt to negotiate an “accountable” reimbursement plan with their employer. Under this type of plan, the reimbursement for qualified expenses is tax-free. Because the employee has been reimbursed, he or she no longer claims a deduction for the expenses, thus eliminating the miscellaneous deduction. Or, to defer the expenses to a year not affected by the AMT. Another strategy is to either become self-employed or start an entity such as an S Corporation or a limited liability company (LLC) and have your employer pay your entity versus you as an employee. Then you can deduct your employee business expenses through the entity and it will offset against your income. You will pay taxes on the net amount. However, there are other issues and concerns regarding having your own entity that are beyond the scope of this article.

5. Personal Exemptions – Personal exemptions for dependents provide no benefit when taxed by the AMT method. Therefore, divorced or separated parents should carefully consider which party should claim the exemption for a dependent child.

6. Standard Deduction – Since the regular tax standard deduction is not allowed as an AMT deduction, taxpayers affected by the AMT should always itemize. While the benefit of some deductions will be lost, there is still a partial advantage. Even the smallest of charitable deductions will benefit at a minimum of 26% (the lowest bracket for the AMT).

Deductions Not Affected by AMT
1. Charitable Contributions – Donations made to charitable organizations are deductible for both the regular and AMT tax calculations.

2. Investment Interest – Such as margin interest are deductible for both the regular and AMT tax calculations.

Incentive Stock Options (ISO) & AMT - If an option is a qualified option (also known as an incentive stock option), then for regular tax purposes, no amount of income is included in income
either at the time the option is granted or at the time it is exercised. Income or loss is recognized when the stock is sold. However, to qualify for this treatment, the stock acquired under the option must be held for:

• More than 1 year after the stock option was exercised, AND
• More than 2 years after the option was granted.

The gain or loss from the sale of ISO stock is generally a capital gain or loss. The gain for regular tax purposes will be the difference between the exercise price and the sales price. If the stock is sold prior to the required holding period, the income to the extent of the bargain element will be treated as ordinary income (wages).

For AMT purposes, taxpayers recognize alternative minimum taxable income (AMT preference income) equal to the excess of the fair market value of the stock on the exercise date over the exercise price. This creates three effects for AMT purposes:

• Preference income in the exercise year, and
• A different stock basis for AMT gain or loss (AMT basis = Exercise price and REG tax basis equals
grant price), and
• Since the ISO preference is a deferral item of preference, an Alternative Minimum Tax Credit
carryover may also be generated.

Finally, some state like California have their own version of the AMT tax too!

The above technical reference is provided as a courtesy to the reader by David Silkman, CPA, MST, Broker, Silkman & Associates Accountancy Corporation and SilkRoad Realty, Inc. The information is technical in nature, may not include all the details on a particular subject and may require review of the reader’s circumstances by a professional. You should consult with your tax advisor.

David S. Silkman is a CPA, has a Masters in Taxation (MST) and is a licensed real estate broker. He specializes in real estate tax laws and accounting. If you have any questions, please do not hesitate to call him at 310.479.7020 x301, email him atdavid@saacpa.com or visit www.saacpa.com orwww.SilkRoadRealtyInc.com. Thank you.