On December 22, 2017, The Tax Cuts and Jobs Act was signed into law. The information in this article predates the tax reform legislation and may not apply to tax returns starting in the 2018 tax year. You may wish to speak to your tax advisor about the latest tax law. This publication is provided for your convenience and does not constitute legal advice. This publication is protected by copyright.
- 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 tax—the regular way that most everyone understands, and the alternative method. Your tax will be the higher of the two.
So what is the alternative 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 (AMT). 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.
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:
- 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.
- 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.
- 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.
- 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. Another strategy would be to defer the expenses to a year not affected by the AMT.
- 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.
- 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).
Caution: Although not frequently encountered, incentive stock options (ISO) can have a profound impact on the AMT, and clients are strongly encouraged to seek our advice prior to exercising incentive stock options.
The AMT is an extremely complicated area of tax law that requires careful planning to minimize its effects. Please contact this office for further assistance.