By Jason B. Miyashita
As more and more Americans become subject to the alternative minimum tax, knowing the factors that trigger the tax and strategies to minimize it become increasingly important.
When first introduced in 1969, the alternative minimum tax was widely acknowledged to be a “rich man’s tax” — a fallback tax for those taxpayers with big incomes and numerous deductibles. But because it has been adjusted for inflation only twice in 30 years, it is now encroaching upon the middle class. Consider that while only 19,000 people owed the alternative minimum tax in 1970, millions are paying it now.
The mechanics of the alternative minimum tax are complex. But a general understanding of how the tax works and what triggers it can help you minimize or avoid it — and even use it to your advantage.
The alternative minimum tax truly functions as an “alternative” tax system. It has its own set of rates and rules for deductions, which are more restrictive than the regular rules. It operates in parallel with the regular income tax system in that if you’re already paying at least as much under the “ordinary” income tax as you would under the alternative minimum tax, you don’t have to pay it. But if your ordinary tax falls below this minimum, you have to make up the difference by paying the alternative minimum tax.
Although those with higher incomes are more susceptible to the tax, many other factors — such as the amount of your exemptions or deductions — can also prompt the tax. Even commonplace items, such as a deduction for state income taxes or interest on a second mortgage, can set off the alternative minimum tax.
Alternative minimum tax rates start at 26%, rising to 28% at higher income levels. This compares with regular federal tax rates, which start at 10% and step up to 39.6%. Although the rates may appear to cap at a lower rate than regular taxes, the alternative minimum tax calculation allows significantly fewer deductions, making for a potentially bigger bottom-line tax bite.
Unlike regular taxes, you cannot claim exemptions for yourself or other dependents, nor may you claim the standard deduction. You also cannot deduct state and local taxes, property tax or a number of other itemized deductions, including home equity loan interest if the loan proceeds are not used for home improvements. Accordingly, the more exemptions and deductions you normally claim, the more likely it is that you’ll have an alternative minimum tax liability.
On the positive side, the law does allow taxpayers to apply a special exemption designed to prevent the tax from applying to those with modest incomes. For the 2015 tax year, it is $83,400 for joint filers and $53,600 for single filers.
Certain circumstances and tax items are likely to trigger the AMT:
- If your gross income is more than $100,000.
- If you have large numbers of personal exemptions.
- If you have significant itemized deductions for state and local taxes, home equity loan interest, deductible medical expenses (alternative minimum tax has a slight difference) or other miscellaneous deductions.
- If you exercised incentive stock options during the year.
- If you had a large capital gain, which may reduce or eliminate the AMT exemption amount.
- If you have passive income or losses.
- If you received income from private activity municipal bonds.
If any of the above applies to you, you should complete the alternative minimum tax worksheet when preparing your taxes. If you don’t, rest assured that the IRS will. And if it finds that you owe the tax, it will add penalties and interest.
Because large one-time gains and big deductions that trigger the tax are sometimes controllable, you may be able to avoid or minimize the impact by planning ahead. Here are some practical suggestions:
- Time your capital gains. You may be able to delay an asset sale until after the end of the year or spread a gain over a number of years by using an installment sale. If you’re looking to liquidate an investment with a long-term gain, you should review your alternative minimum tax consequences and determine what impact such a sale might have.
- Time your deductible expenses. Many itemized deductions are not deductible when computing the alternative minimum tax. When possible, time payments of state and local taxes, home equity loan interest (if the loan proceeds are not used for home improvements) and other miscellaneous itemized deductions to fall in years when you won’t face the tax. Since they are not alternative minimum tax deductible, they will go unused in a year when you pay the tax. The same holds true for medical deductions, which face stricter deduction rules. But also keep in mind how deferred deductions might impact next year’s tax and potential exposure to the alternative minimum tax. And if you do not itemize because the standard deduction is greater than itemized deductions but still find yourself subject to the tax, you may want to consider itemizing, which may result in a lower alternative minimum tax.
- Look before you exercise. Exercising incentive stock options is a red flag for triggering the alternative minimum tax. What’s more, ISO proceeds — the excess of the fair market value over the strike price or exercise price — are taxable under the alternative minimum tax, while they are not under the ordinary tax calculation. There are several strategies you can employ to minimize your alternative minimum tax exposure with ISOs.
First, try to exercise the options when the price is low, so that any gains will be taxed at capital gains rates when the shares are later sold. Second, stagger exercises over a number of years so that you stay under the level that triggers the tax each year. And third, by selling the options in the year of exercise you may be able to minimize your alternative minimum tax exposure. Because ISO tax issues are complex, you should consult with your investment advisor before exercising ISOs.
- Invest selectively in municipal bonds. Although interest on most municipal bonds is exempt from regular and alternative minimum tax, interest on municipal bonds that fund a private activity are taxable for alternative minimum tax purposes. So if you are subject to the tax, make sure to factor it in when calculating after-tax returns on private activity bonds. Also keep in mind that the tax exemption for municipal bonds is more “valuable” if you are in the top tax brackets. Since the top alternative minimum tax rate is 28% — compared with 39.6% for ordinary income — those subject to the tax may find that a taxable bond will yield a higher rate of after-tax return.
- Minimize passive activity losses. Losses from rental real estate, tax-shelter farm activities and similar passive activities are not deductible in computing alternative minimum tax income. For certain taxpayers, this can pose an issue if the passive activity loss is deductible for regular tax purposes.
- Use home equity loans wisely. The alternative minimum tax limits the deduction on home equity loans to interest on proceeds used to purchase, build or substantially improve a principal or second residence. Amounts used for other purposes are not deductible under the tax. This is an important point to keep in mind when using a home equity loan for other purposes, and you may wish to pursue alternate funding for such purposes if you will be subject to it. You should make sure to keep accurate records of what is borrowed, specifically for home improvement, and keep receipts of all expenditures.
Keep in mind that the rules and reporting associated with the tax are complex, and the planning issues that relate to it are comprehensive. If you think you may be subject to the alternative minimum tax, let me help you evaluate what steps you can take to avoid or minimize your exposure. n
— Jason B. Miyashita is the senior investment management consultant and vice president – wealth management at the Asia Pacific Group at Morgan Stanley. He may be contacted at (671) 475-8890 or [email protected].