The alternative minimum tax (AMT) began life as a defense against wealthy taxpayers who deducted their way out of paying income tax. The purpose of the tax was to ensure that everyone paid at least a minimum amount of tax. Unfortunately, the factors that determine whether or not you have to pay the AMT haven’t been updated over the years. As a result, more and more middle-income people are getting caught by the AMT. The factors that affect this are the:
Exemption amount—the minimum net income that you can earn before the tax might kick in
Tax rates
The exemption amount hasn’t changed since the AMT was created (except for small increases that are good for only one year). The tax rate for AMT has stayed the same, but the regular tax rates have gone down. So, instead of the AMT tax rate being much lower than regular tax rates, as it used to be, the regular tax rates are sometimes lower than the AMT rate.
The alternative minimum tax is a parallel tax system. This means that after you’ve filled out your regular tax return, you then have to fill out the AMT (Form 6251) and compare the two taxes. You then pay the higher of the two taxes—the regular tax or the AMT tax. Since you pay the higher of the two taxes, you can see why having an AMT tax rate that’s higher than the regular tax rate can be a problem. Also, a lot of deductions that you can claim on your regular tax return, aren’t allowed for the AMT.
There’s no easy way to determine whether or not you’re subject to the alternative minimum tax. Some indicators might be:
Having more than 3 children
Claiming employee expenses on your Schedule A
Exercising (but not selling) incentive stock options
TaxCut will calculate the AMT for you. If it looks as though you might be subject to the AMT, TaxCut will ask you additional questions to help determine whether or not you actually do owe AMT. Sometimes it gets a little more complicated and you need to recalculate an amount using the AMT rules. If you need to recalculate an amount, TaxCut will let you know.
Most of Form 6251, which you use to calculate the AMT, has you adding back amounts that you deducted on your regular tax return. The goal is to first calculate alternative minimum tax income (AMTI).
To do so, you first take your income after itemizing deductions (if you itemized) and before taking your personal exemptions. If you didn’t itemize, then you take your adjusted gross income (AGI). This means that you can’t claim your personal exemptions, which reduce your income on your regular tax return by $3,400 per person (less for high-income individuals) in 2007, for AMT purposes.
In addition, if you itemize, many of the deductions that you can take on your regular tax return aren’t deductible for the AMT. This means that you need to add them back into your income. You need to add back deductions that you claimed for:
State or local income or sales taxes.
Miscellaneous itemized deductions above the 2% threshold.
Medical expenses not in excess of 10% of adjusted gross income. (The threshold for regular tax purposes is 7.5%.)
Certain mortgage interest. In the regular tax system you can deduct almost all of your mortgage interest (subject to limitations based on the size of the loan, see Interest on Home Mortgages for details). However, for AMT purposes, if you use any of the mortgage for a purpose other than to buy, build, or substantially improve your first or second home, you can’t deduct the associated interest. This affects you if you refinanced your mortgage and used some of the money to buy a boat or a new car.
The alternative minimum tax has slightly different depreciation rules than the regular tax system has. Under the AMT, the depreciation is often lower. This is especially true for items that were put into service before 1999. For items put into service (in a business or for investment purposes) before 1999, you must calculate a separate AMT depreciation. Usually, this means that the depreciation is spread over more years and at a less favorable rate.
This will also affect the amount of capital gain or loss that you realize when you sell the asset that’s being depreciated. The basis of the property is equal to its cost adjusted up or down by certain amounts, including a downward adjustment for depreciation allowed or allowable. If your depreciation is lower for AMT purposes than for regular tax purposes, then your basis will be higher. Because you have a higher basis, your gain will be lower or your loss will be greater. Unfortunately, this needs to be tracked separately.
Note that this applies only to assets that were put into service before 1999. Any asset placed into service after 1998, isn’t subject to the AMT depreciation system, which makes recordkeeping much easier.
There’s a discussion about preference items in the Form 6251 instructions. The incentive stock option (ISO) is a preference item. This is often a major reason why you have to pay alternative minimum tax.
When you exercise an ISO but don’t sell the stock in the same year that you exercise it, you don’t have any income or loss to report on your regular income tax return. It’s as though the transaction never happened. However, for AMT purposes, you have to assume that something did happen.
Usually, an ISO allows you to buy stocks at a price lower than the current fair market value of the stock (if it’s publicly traded). The difference between the amount you paid for the stock and the fair market value of the stock on the day you exercised your option is an income item for AMT purposes. For details, see Incentive Stock Options and the Alternative Minimum Tax.
Generally, income on municipal bonds isn’t taxable on your regular tax return. However, if any of those municipal bonds are private activity bonds, then you might have taxable income for AMT purposes. This is only true for private activity bonds issued after August 7, 1986. The Form 1099-DIV that you receive should indicate how much of your tax-exempt interest, if any, is subject to AMT.
TaxCut will help you figure out which items need to be entered in the income section of Form 6251. When you’re done, TaxCut will calculate your alternative minimum tax income (AMTI). Then, you get to subtract an exemption amount that’s based on your total AMTI and your filing status.
This amount hasn’t changed much since the AMT was introduced. However, over the past several years, Congress has passed laws that change the exemption amount temporarily. Unfortunately, all of these temporary exemption amounts have expired, so this year’s exemption amount reverts back to the amount that existed in 2002.
This means that the exemption amounts for 2007 are $45,000 if you file a joint or qualified widow(er) return, $33,750 if you file a single or head of household return, and $22,500 if you and your spouse file separate returns. These amounts are phased out at the rate of 25 cents for each $1 of AMT income over the following amounts:
$150,000 if your filing status is married filing jointly or qualifying widow(er)
$112,500 if your filing status is single or head of household
$75,000 if your filing status is married filing separately
After you subtract the exemption amount from the AMTI, you arrive at the amount of income that is subject to the alternative minimum tax. For income up to $175,000 ($87,500 if married filing separately), the AMT tax rate is a flat 26%. If you’re income is over $175,000, then the AMT tax rate is 28%. If you have any income that is taxed at a lower rate, such as long-term capital gains or qualified dividends, it is still subject to those rates—not the AMT tax rate.