Alternative Minimum Tax - An Explanation

Introduction: Alternative Minimum Tax (AMT) mainly effects upper income taxpayers. “When I see an upper income taxpayer with significant real estate taxes, state income taxes and or high miscellaneous deductions such as employee business expenses I think immediately of AMT” says Joseph D Lutz, CPA from Littleton, Colorado.

The schedule below presents a common AMT candidate. The column on the left presents the taxpayer’s tax calculation based on the regular federal income tax. The column on the right presents the same taxpayer’s income tax calculated under the Alternative Minimum Tax (AMT). The federal law requires the taxpayer pay the higher of the two income tax calculations. 2006 Federal Income Tax rules and Joint income tax rates have been used below.

Alternative Minimum Tax - An Explanation

		Calculation of Individual
		Income Tax Under
	See	Regular	Alternative
	Footnote	Income	Minimum
	Below	Tax	Tax

Income

Salary		300,000	300,000
Qualified dividends	A	10,000	10,000
Long Term Capital gains	A	15,000	15,000

Adjusted Gross Income		325,000	325,000

Itemized Deductions
Home mortgage interest expense		-20,000	-20,000
Margin Interest (Investment interest)	B	-5,000	-5,000
Real estate taxes	C	-6,000	*
State Income taxes	C	-21,500	*
Charitable contributions		-7,000	-7,000
Miscellaneous deductions
Business and investment expenses	C	-10,000	*
Disallowed itemized deductions	D	9,990
Exemptions allowed	E	-7,700	-26,800

Federal Taxable income		257,790	266,200

Federal income tax	F	61,452	68,436

Footnotes to the schedule above:

A-	Qualified dividends and long term capital gains are generally taxed at a maximum rate of 15%. However under the AMT, calculation they may be taxed at a higher rate.
B-	Mortgage interest on a principle residence, investment interest expense (most often margin interest for the investor) and charitable contributions are the best deductions for an AMT taxpayer. You must be able to itemize your deductions in order to take advantage of expenditures. Margin interest is only deductible to the extent you have income such as interest, dividends or short term capital gains. In other words, if you do not have interest, dividend or short term capital gain income, you generally can not deduct margin interest.
C-	Real estate taxes, state income taxes and miscellaneous itemized deductions are the enemy of the upper income taxpayer. Notice that none of these are deductible under the AMT calculation in the column on the right above.
D-	There are two limitations to itemized deductions, in this example. First, Miscellaneous Itemized Deductions are limited by 2% of Adjusted Gross Income. The Miscellaneous Itemized Deductions in the above schedule on the left are $ 10,000. This deduction is reduced by $ 6,500. Second, when Adjusted Gross Income is in excess of $ 150,500, certain Itemized Deductions are reduced by 3% of this excess. In this case an additional $ 3,490 of itemized deductions are not allowable. These two reductions in Itemized Deductions total $ 9,990 (6,500 + 3,490)
E-	Exemptions generally are $ 3,300 per individual in the family. Under the regular income tax calculation exemptions begin to be phased out (reduced) at Adjusted Gross Income of $ 225,750. In the case above, the exemptions have been reduced to $ 1,540 per person or $ 7,700 for the entire family. Under the AMT schedule there is an exemption of $ 26,800 for this taxpayer. The AMT exemption in the above example is not related to the number of family members. Instead, this exemption begins at $ 62,550 and decreases as the AMT taxpayers’ income increases above $ 150,000
F-	The Alternative Minimum Tax (AMT) above is $ 6,984 higher than the Regular income tax. Each individual’s income tax situation is different and may vary significantly. This is meant as an example only. Each individual should confer with his tax advisor on a regular basis in order to plan for the often surprising effects of AMT.

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