Alternative Minimum Tax basics for individuals

The Alternative Minimum Tax (AMT) was designed to set a baseline for the proportion of taxes a taxpayer must pay, regardless of the deductions or credits claimed under standard U.S. tax regulations. Unlike the regular income tax system, the AMT operates with its own rules, recalculating income by adding back certain tax preference items to adjusted gross income. This approach disallows specific deductions, imposing a tax on a broader base of income.

While initially targeted at high-income earners, the reach of the AMT has expanded over the years, ensnaring a broader spectrum of taxpayers. Individuals with significant itemized deductions, such as state and local taxes, accelerated depreciation, and net operating losses are particularly susceptible to the AMT. Additionally, certain types of income, such as capital gains and tax-exempt interest from private activity bonds, can trigger the AMT for unsuspecting taxpayers.

Who has to pay the AMT?

Generally speaking, if you are a relatively high earner and have significantly reduced your tax liability through deductions, you may need to consider the AMT. Please note that there is also a Corporate Alternative Minimum Tax (CAMT); however, our discussion will center on the AMT for individuals.

To determine whether the AMT applies to you, start by calculating your regular taxable income and taxes owed using Form 1040, along with any relevant schedules. The AMT calculation becomes relevant if your income approaches or surpasses specific exemption amounts. For 2024, these exemption thresholds are set at $85,700 for single filers and $133,300 for those filing jointly. Below these income levels, the likelihood of owing AMT diminishes significantly.

If you used itemized deductions that significantly reduced your regular tax liability, it increases the probability that you will need to calculate the AMT. The AMT disallows or adjusts many deductions, so note that your taxable income under the AMT could look very different from your regular taxable income.

How to determine taxable income under the AMT

To calculate your AMT income (AMTI), you’ll modify your adjusted gross income (AGI) by adding back certain items that are otherwise deductible under the regular tax system. You can use IRS Form 6251 to calculate your AMTI, but due to the complexity of these calculations and the risk of potential penalties associated with underpayment, it’s advisable to work with a CPA when calculating your AMTI.

Here’s a brief overview of items that must be added back to your AGI for AMT purposes:

• State and local tax deductions.

• Interest on home equity loans unless the loan was used to buy, build, or substantially improve your home.

• Interest from private activity bonds.

• Net operating loss deductions.

• A portion of gains from the sale of qualified small business stock.

• If you exercise Incentive Stock Options (ISOs) and don’t sell the stock in the same year, the difference between the exercise price and fair market value is considered part of your AMTI. This could lead to tax liability for potential profits that haven’t been realized yet.

• Depreciation methods for AMT may require longer periods than those for regular taxes, creating differences in taxable amounts each year.

• Certain business credits allowable under regular tax rules, like the Low-Income Housing Credit or Work Opportunity Credit, may be reduced or unavailable for AMT purposes.

Please note that this list is not exhaustive, nor does it fully detail all the adjustments that can go into calculating your taxable income under the AMT. However, it does illustrate the potential differences between your regular taxable income and AMTI.

How to calculate any taxes owed under the AMT

Once you’ve calculated your AMTI, you’ll need to calculate your tentative minimum tax (TMT), which is the difference between your AMTI and your AMT exemption. In 2024, the exemption is set at $85,700 for single filers and $133,300 for joint filers. However, the AMT exemption amount is phased out at higher income levels, reducing the exemption by 25 cents for every dollar of AMTI above the threshold. For 2024, the phase-out begins at $609,350 for single filers and $1,218,700 for joint filers.

To illustrate, let’s imagine you are a single filer with a regular AGI of $200,000. You have taken deductions that reduce your taxable income significantly, leading to a regular tax liability of $20,000. However, after making necessary AMT adjustments, your AMTI becomes $250,000. Here’s how you would calculate your TMT and taxes owed:

1. Subtract your AMT exemption from your AMTI. Yours would be $164,300.

2. Apply AMT tax rates. For incomes up to $232,599, the tax rate is 26%. Beyond that, the rate is 28%. Your AMT would be 26% of $164,300, or $42,718.

3. Compare TMT with regular tax. Since your TMT exceeds your regular tax ($20,000), you would need to pay the AMT of $22,718 in addition to your regular income tax.

Strategies for reducing or avoiding the AMT

Minimizing your AMT liability requires strategic planning, particularly concerning deductions, income timing, and investment decisions. While this list is not exhaustive, here are some strategies to consider:

Evaluate your yearly tax position

First and foremost, assess your tax situation with a tax professional to identify potential AMT triggers. Understanding the implications of your financial decisions on your AMT status each year can help you make informed, tax-efficient choices.

Restructure property taxes

Real estate and personal property taxes are generally not deductible under the AMT unless they are incurred in a business context. For instance, if taxes are deductible on Schedule C (for businesses), Schedule E (for rentals), or Schedule F (for farms), they can be deductible from AMTI as well. If feasible, consider converting vacant land into a farm or rental to deduct the associated real estate taxes from your AMTI.

Invest in tax-exempt bonds

Consider investing in tax-exempt bonds issued before 2009 that are not categorized as private activity bonds. Mutual funds often provide two types of state bond funds – one that includes private activity bonds and one that does not. Reviewing fund literature carefully can guide you in choosing the right investment to avoid AMT complications.

Manage the sale of qualified small business stock

In the year you sell qualified small business stock, aim to minimize other AMT adjustments. This approach helps maximize the gain exclusion available on the sale, reducing potential AMT liability.

Carefully consider your depreciation methods

Depreciation is generally calculated more slowly for AMT purposes. If you have used accelerated depreciation methods to reduce your regular tax bill, a significant portion of this depreciation could be added back to your AMT income. If you find yourself regularly subject to the AMT, consider opting for slower depreciation methods. This strategy could minimize the discrepancy between your regular tax liability and AMT.

Avoid prepaying certain taxes

In years when you are subject to the AMT, avoid prepaying fourth-quarter state and real estate taxes in December. Under AMT, you likely won’t benefit from these payments unless they’re incurred in a business context.

Seek professional guidance for your AMT calculations

From determining whether the tax applies to you to calculating your AMT income, each step requires expertise and attention to detail. Given the complexity of the AMT, those concerned about potential liability would benefit from the guidance of a tax professional. They can ensure your calculations are correct and discuss strategies for reducing your AMT liability.

While this article offers a basic overview of the AMT, the intricacies involved in real-world applications can vary widely from one individual to another. For those seeking deeper insights or facing specific challenges with the AMT, our experts are equipped to provide detailed, personalized advice.

If you’d like to explore ways to optimize your tax strategies in light of the AMT, please contact our office.