Back to library home

Understanding the Alternative Minimum Tax (AMT)

Your total tax bill consists of two parts — the regular tax and the alternative minimum tax (AMT). The alternative minimum tax was enacted in 1970 to ensure that the super rich pay a minimum amount of tax, or their “fair share”, regardless of how many deductions and credits they take. If your income is low enough, you will not have to pay any alternative minimum tax. Below is a technical explanation of how this tax works, with the hope that you will understand it better.

Here's how it works. Let's start with your regular tax. To calculate it, start with your income. Then subtract deductions, some of which are the: IRA deduction (a deduction to encourage people to contribute to their retirement plan), tuition and fees, moving expenses, mortgage interest, property tax, charitable contributions, and the standard deduction. Then subtract your exemption, which is the number of people in your household times a dollar amount. What you're left with is your taxable income, and the regular tax is a percentage of this. But we're not done. You now get to take various credits, such as the: child tax credit, energy credits (for adding insulation, solar panels, etc to your home), dependent care credit (for sending your kids to daycare or hiring a nanny), education credits, foreign tax credit. The final result is your regular tax.

It's possible that because of your deductions, exemptions, and credits you may owe very little tax or no tax. So Congress said that these people would recompute their tax using different rules — one that allows fewer deductions and credits — and thus they would pay a sizeable amount in taxes. The alternative minimum tax is between 26% or 28% of your income and does not allow many deductions.

A couple with 2 kids and $40,000 in income would have no tax. But they don't need to worry about the AMT as it only affects higher income taxpayers. In practice, you may have AMT if you're single and make over $200,000, or married and make over $250,000. Depending on your situation, you may have to pay AMT even if your income is less.

You're also likely to have AMT if you exercise incentive stock options (ISO's). If you exercise your ISO's and hold the shares then the phantom profit — the difference between the market price and the option strike price —gets added to your AMT taxable income and will be taxed at between 26% and 28%.

You're also likely to have AMT if you have lots of private activity bond interest. This is interest paid by some muni bonds, especially those that are public-private partnerships. Most bonds don't have any private activity bond interest. The interest is tax-free for the regular tax, but it is usually subect to the alternative minimum tax.

Deductions not allowed under AMT, with examples

When computing your regular tax, you're entitled to various deductions, all of which will reduce your regular tax. But many of these deductions are not allowed under the the alternative minimum tax, although some of them are. Here is a partial list of what's not allowed under AMT:

Deduction for state tax
  • Federal law allows you to deduct the state and local tax you paid on Schedule A. But because of the AMT you may lose part or all of the deduction.
  • The state disability insurance (SDI) tax and state unemployment insurance (SUI) tax paid by the employee are also deductible for the regular tax only. (In California, SUI is paid by the employer.)
  • Someone living in California and making $200,000 would likely pay around $17,000 a year in state income tax. He/she would be able to deduct this $17,000, but because of the AMT only the first $13,823.00 of state income tax would be really deductible.
  • If the taxpayer paid only $13,823 in state income tax and deducted this on their federal return, their federal tax would be $45,351 (they would still owe an additional $2,661 to the state of California). But if they paid an additional $1,000 in state tax during the year then their regular tax would be reduced to $45,021 — less by $330 (33% of $1,000). But the AMT would be exactly $330. Thus the total tax would still be $45,351.
  • In fact, none of the state income tax about $13,823 would make a difference to the total federal tax.
  • See the picture below for an example.
  • Some good news: Your state tax income refund is usually taxable on your federal return (not taxable if you take the standard deduction). But if you fall in AMT and you receive a state income tax refund the following year, you may be to to exclude part or all of the state income tax refund from your federal tax because the AMT prevented you from deducting part or all of it.

  • A couple living in California and making $250,000 would likely pay around $19,000 a year in state income tax. They would be able to deduct this $19,000, but because of the AMT only the first $14,116.00 of state income tax would be really deductible.
  • If the taxpayers paid only $14,116 in state income tax and deducted this on their federal return, their federal tax would be $53,214. But if they paid an additional $1,000 in state tax during the year then their regular tax would be reduced to $52,884 — less by $330 (33% of $1,000). But the AMT would be exactly $330. Thus the total tax would still be $53,214.
  • In fact, none of the state income tax about $14,116 would make a difference to the total tax.
  • Some good news: Your state tax income refund may not be taxable on your federal return. See the bullet point above for more details.
Deduction for property tax
  • Federal law allows you to deduct the property tax you paid on Schedule A. Property tax includes property tax on your home as well as on your cars and boats. But because of the AMT you may lose part or all of the deduction.
  • Consider our example above of a single taxpayer in California making $200,000 and paying $13,823 a year in state income tax. Any amount of property tax paid would make no difference to the federal total tax because the regular tax would decrease due to the property tax deduction, but the AMT would increase by the exact same amount.
  • Some good news: Even though the deduction makes no difference to your total federal tax, it will reduce your state income tax because the deduction will be allowed on your state income tax return.
Deduction for home equity interest
  • Federal law allows you to deduct the home equity interest on a loan of up to $100,000 on Schedule A, as long as you don't use the money to buy municipal bonds.
  • You can use that $100,000 for anything, including improving your home, or paying for a trip around the world.
  • If you use the $100,000 for anything other than buying or improving your home, then the mortgage interest is not allowed under AMT, and you may lose part or all of the deduction.
  • Consider our example above of a single taxpayer in California making $200,000 and paying $13,823 a year in state income tax. Suppose the person took out a home equity line of credit and used the money to buy a car. The interest on this loan makes no difference to the total federal tax, because the regular tax would decrease due to the home equity interest deduction, but the AMT would increase by the exact same amount.
  • Some good news: Even though the deduction makes no difference to your total federal tax, it will reduce your state income tax.
Miscellaneous deductions such as unreimbursed employee expenses, tax preparation fees, investment fees, etc.
  • Federal law allows you to deduct miscellaneous deductions such as unreimbursed employee expenses, tax preparation fees, investment fees, etc subject to the 2% of AGI rule.
  • This means that only the amount of fees above 2% of your income are deductible. So if you're a single taxpayer making $200,000, then only the miscellaneous deductions in excess of $4,000 are deductible.
  • Consider our example above of a single taxpayer in California making $200,000 and paying $13,823 a year in state income tax. Suppose the person has $5,000 in miscellaneous deductions. The allowable deduction is $1,000. The deduction makes no difference to the total federal tax, because the regular tax would decrease due to the deduction, but the AMT would increase by the exact same amount.
  • Some good news: Even though the deduction makes no difference to your total federal tax, it will reduce your state income tax.
Exemptions
  • Federal law allows you to take a deduction for exemptions. The deduction is the number of people in your household times a fixed dollar amount, which is $3,650 in 2010. For high income taxpayers, the exemption may be phased out.
  • But the deduction for exemptions is not allowed under AMT. As with the other examples, the exemption deduction reduces your regular tax by a fixed amount, but the AMT increases by this exact same amount.
Accelerated depreciation for sole proprietorships
  • Federal law allows you to deduct or write-off the cost of assets (like computers, cameras, cars) that you use for your business. This is called depreciation. As an aside, you will likely have to pay tax if you later you sell the asset.
  • Federal law allows you to write-off assets all at once or over a number of years. That is, you can deduct it all in one year, or over a number of years. The election to write-off assets all at once is limited, so in general you would have to write-off assets over a period of years. For example, computers would be typically be off over 5 to 6 years. Writing off all your assets as once is known as section 179 and you may read about it here.
  • If you write of your assets over a number of years you can use something called accelerated depreciation. This lets you write off the asset very quickly, deducting more of the cost in the first years, as opposed to deducting the cost evenly over all of the years.
  • But the AMT does not allow accelerated depreciation. So for a computer depreciated over 5 years, accelerated depreciation might prescribe a depreciation deduction of 32% or 40% of the total asset value in the first year. But straight line depreciation would only allow a deduction of 20% each year. Thus some of your deduction is not allowed under AMT.

 

Example showing how alternative minimum tax prevents an additional deduction for state income tax

 

Deductions allowed under AMT

Now here's a partial list of what is allowed under the the alternative minimum tax (AMT):

  • Deduction for mortgage interest on your primary and secondary home.
  • Deduction for charitable contributions.
  • Deduction for investment interest. Investment interest means interest when you buy shares on margin or when you short shares, certain dividends paid while you're shorting a stock, property tax on a home held purely for investment.
Above the line deductions are also allowed. These are lines 23 to 35 of form 1040 and include:
  • Educator expenses
  • Heath savings account contributions
  • Moving expenses
  • ½ of self-employment tax
  • Retirement contributions and health insurance for self-employed individuals
  • Alimony paid
  • IRA contributions
  • Student loan interest
  • Tuition and fees

 

Credits allowed and disallowed under AMT

Due to recent legislation, most credits are allowed under the AMT.

Business expenses

Unlike personal deductions, business deductions are allowed in full because it's a cost of doing business. The deduction for property tax on your personal home may be limited or eliminated if you're in AMT. But if you rent out your home, then your home is considered business property. In this case, the property tax paid is a business expense and is reported on Schedule E. It is allowed in full and is not phased out.

Similarly, unreimbursed employee expenses are reported on Schedule A, but as noted above they are not allowed under AMT rules. But if your start your own business, these expenses are business expenses and are allowed in full on Schedule C. For example, tax preparation fees for your Schedule C business are allowed in full. But tax preparation fees for your personal return are reported on Schedule A and are not only subject to the 2% of AGI rule (that only the amount in excess of 2% of your AGI are deductible), but are also are not allowed under AMT.

The super rich may not have any AMT

Ironically, the alternative minimum tax (AMT) may not affect the super super rich — that is, those making A TON of money. There are two reasons for this.

First, long-term capital gains are taxed at a flat 15% and are not subject to AMT. Long term capital gain refers to profit from selling stocks, bonds, options, mutual funds, real estate, etc. Suppose a very rich person sold millions of dollars worth of stock and that was their only income. They would pay a flat 15% in taxes on the profit. They would not be subject to AMT. The AMT rate is between 26% and 28% of your income, but there is no AMT long term capital gains. This is why Warren Buffet's tax rate was so low even though he made millions.

Many decades ago, capital gains were considered ordinary income and would have subject to AMT, but that is not the case any more.

A special provision of the Bush tax cut is that qualified dividends are taxed at 15% and are not subject to AMT. Dividends are a share of profits that companies pay to shareholders (not all companies pay dividends). A dividend is qualified if the the shares were held for 60 days, and if the company is traded on a US stock exchange and is not a REIT (real estate investment trust). For example, if you own a $1,000,000 worth of Target shares, you would receive about $10,000 a year in dividends; but be aware that the dividend payout changes every year based on the companies profits. So if your only income is $1,000,000 in qualified dividends, you would pay a flat 15% in taxes, and no AMT.

The Bush tax cut was supposed to expire at the end of 2010, meaning that in 2011 all dividends would have been taxed as ordinary income subject to the higher tax rates (currently the highest is 35%) as well as AMT. But the Bush tax cuts were extended for two years.

Second, if your ordinary income is very high and you don't have many deductions, then your regular tax will already be larger than 28% of your income, and you won't have to pay an AMT. For example if your salary is $1,000,000 and you withhold $96,000 of California state income tax during the year (which is approximately your total California tax the entire year), your total federal tax will be $292,766 and you will have no AMT. Your federal tax is already about 29.2766% of your income, so AMT (with a maximum rate of 28%) would not apply.

But if your salary were $500,000 and you withhold $46,000.00 of California state (which is approximately your total California tax the entire year), your total federal tax will be $136,500. Your total federal tax includes $135,266 of regular tax, which is about 27.0532% of the total $500,000. There is AMT of $1,234.

The AMT exemption

As people's incomes rise, more and more people become subject to the alternative minimum tax (AMT). The Bay Area has many people making well over $100,000 a year, and many of them will find themselves subject to the AMT. Every year in the press we hear about congress enacting an AMT patch or increasing the AMT exemption.

The AMT exemption controls how many people fall under AMT. For 2010, the AMT exemption is $47,450 for single taxpayers, and $72,450 for married taxpayers filing jointly. If your income is below this threshold then you have no AMT. If your income is above this threshold then you have have AMT, but likely only if you make around $200,000 if single and $250,000 if married. By raising the AMT exemption by just $10,000, thousands of people will escape AMT.

If you're wondering why AMT affects single people making $200,000 but married people making $250,000, not $400,000, the reason is the marriage penalty.

If your income is very high, the AMT exemption itself starts to get phased out. So high income taxpayers may find themselves paying even more AMT.

While qualified dividends and long term capital gains are not taxed under the AMT, they increase your income and thus phase out your AMT exemption. Thus, more of your income becomes subject to AMT. So for example, the person above who makes $150,000 and pays $14,823 in state income taxes has $330 of AMT. If this person also has $1,000 in capital gains, the AMT rises to $395 because their AMT exemption has decreased.

California's alternative minimum tax

California also has an alternative minimum tax, with a rate of 6.65%. However, it's rare. In other words, it's possible to have this tax on your federal tax return but not on your California tax return.

 


Contact Pacific Tax 1040

 

IRS CIRCULAR 230 NOTICE: To the extent that this message or any attachment concerns tax matters, it is not intended to be used and cannot be used by a taxpayer for the purpose of avoiding penalties that may be imposed by law.