Alternative Minimum Tax (AMT) has been with us for quite a while. AMT was first legislated by Congress in 1969 due to perceived abuses by higher-income or high net worth (HNW) taxpayers who were able to make their way through the regular tax system paying little or no tax. Today, however, as many tax practitioners are aware, AMT does not just affect higher-income or high net worth taxpayers, but rather, has gradually come to affect an increasing number of other taxpayers who were never intended to be the target of the AMT regime. For example, in the Tax Court case David and Margaret Klaasen v. Comm’r, TC Memo 1998-241, the only preference item the taxpayer had were the exemption amounts for each spouse and ten children. The taxpayers were still subject to AMT. In James Medis v. Comm’r, TC Summ. Op. 2004-141, another unwary taxpayer got caught in the wide net that is cast by the AMT rules because of miscellaneous itemized deductions.
Generally, AMT involves making certain adjustments (items of income and deductions computed differently for AMT than for regular tax purposes) or modifying income for preferences (items that receive preferential tax treatment for regular tax purposes, but not for AMT purposes). In addition, adjustments and preferences can either be deferral items (modifications that amount to timing differences) or exclusion items (modifications that are treated as permanent differences). The deferral items typically generate an AMT credit which may be applied against regular tax in future years to reduce regular tax liability. Exclusion items do not provide an AMT credit. Common adjustments and preferences include personal exemptions, the standard deduction, medical expenses, itemized taxes miscellaneous itemized deductions, home mortgage interest, and others.
While AMT planning ideas are somewhat limited (after all, the AMT rules are deliberately designed to make it difficult to “bypass” AMT), there are some basic AMT planning ideas that may be effective in assisting clients in various situations.
Personal Exemptions and the Standard Deduction
Taxpayers subject to AMT liability do not obtain any benefit from any personal exemptions. For divorced or separated taxpayers, allowing the other spouse to claim exemptions may be a wise idea. This may be an additional negotiation item in a family law setting. Comparison of federal and state tax liabilities both with and without the exemptions will determine whether allowing the other spouse to claim available exemptions is helpful. The appropriate way to provide the other spouse the right to claim exemptions is properly accomplished through use of Form 8332.
In addition, while we’re all familiar with claiming the higher of the standardized deduction or itemized deductions (and familiar with software that automatically optimizes by claiming the higher of the two), it may be best for an AMT taxpayer to claim the lesser amount in itemized deductions, because some of those deductions may be allowed for AMT purposes (instead of having the standard deduction fully disallowed).
Under current legislation, 2016 is the final tax year in which a taxpayer over 65 (or a taxpayer with a spouse over age 65) can deduct qualifying medical costs in excess of 7.5% of AGI. Other taxpayers must apply a 10% threshold to arrive at their deductible amount. For AMT purposes, only those medical expenses in excess of the 10% threshold may be deducted. Taxpayers subject to AMT might consider use of an HSA or other similar arrangement (such as an FSA). Medical expenses paid through the use of such a plan, in essence, become fully deductible for both AMT and regular tax purposes.
State and local income or sales taxes, personal property taxes and real estate taxes, while allowed for under regular tax, are disallowed under AMT. For taxpayers in high-tax states, this is clearly a major tax disadvantage.
Optimizing the tax year for payment and deduction is one strategy to use to prevent “wasting” a potential deduction for state and local taxes because AMT prevails. Tax projections in November or December are most useful for this. Taxpayers who are not in an AMT situation can make an early payment of fourth quarter state estimated taxes before the end of the tax year to accelerate the deduction for same. For taxpayers who will be subject to AMT, making a state estimated tax prepayment will not be beneficial.
Claiming as much of the state and local taxes as possible on an “above-the-line” basis is another strategy to consider. Claiming business vehicle miles on a Schedule C entitles the taxpayer to claim a portion of the personal property taxes paid on the vehicle on Schedule C too (just as a Form 8829 home office deduction claim provides the ability to claim the portion of real estate taxes attributable to the office space). Note that where this amount of real estate taxes is meaningful, this may make use of Form 8829 preferable over using the simplified home office deduction.
An AMT taxpayer who pays taxes on unimproved or unproductive land can choose to capitalize, rather than expense those taxes. Details on this election are found at Treas. Reg. §1.266-1, and the election is made on a year to year basis. The capitalization of taxes increases the taxpayer’s basis in the property, reducing later capital gains taxes. This is preferable to simply “wasting” the deduction for those taxes under the AMT regime.
In addition, an AMT taxpayer may be in a situation in which their federal tax is the same whether they claim state income taxes or sales taxes. However, if the state allows all federal itemized deductions (other than for state and local income taxes), claiming state sales tax instead of state income tax will generally result in a state tax savings.
Home Mortgage Interest
Under regular tax rules, qualified home mortgage interest on a principal residence and one secondary residence may be deducted. Qualified home mortgage interest can also include acquisition debt (subject to the $1 million limit). Under regular tax rules, interest on home equity debt of up to $100,000 may also be claimed. Under AMT rules, home equity interest is not deductible, while acquisition indebtedness is allowed. This is relevant for clients who are separating or divorcing, since home mortgage indebtedness incurred on a debt to provide funds needed to “buy out” a spouse’s interest in the matrimonial home is considered acquisition indebtedness (and the interest on that debt is allowed under AMT rules). Moreover, under regular tax rules, an interest deduction on a second home may include interest paid on a boat or motor home. However, under AMT rules, interest paid on a boat or motor home is generally not deductible under IRC §56(e)(2).
From an AMT planning standpoint, several strategies exist. One common strategy, particularly for those taxpayers, such as certain HNW taxpayers, is to pay off the home equity indebtedness, since it provides no tax advantage. Paying off home equity indebtedness and incurring the same amount of debt for a transaction that would qualify the debt as acquisition indebtedness, (such as improving the home), which is allowed under AMT, is another effective strategy.
If a loan consists of a mix of acquisition indebtedness and personal indebtedness, debt repayment rules under Treas. Reg. §1.163-8T(d)(1) allow any repayments to be first applied against the personal-use component of the loan first. This will allow the elimination of the personal-use portion of the loan (with nondeductible interest), leaving only deductible acquisition loan interest. Obviously, good recordkeeping is imperative with the use of the interest tracing rules.
Miscellaneous Itemized Expenses
Those expenses such as income tax preparation and accounting fees and unreimbursed employment expenses subject to the 2% floor are not allowed under AMT rules. Sometimes, an alternate acceptable and qualifying method for claiming these expenses will provide an AMT taxpayer with some benefit from being able to deduct some or all of these expenses. For example, tax preparation and accounting fees usually shown on Schedule A can appropriately be allocated and claimed on the client’s Schedule C, Schedule E to deduct the amounts of those fees allocable to business or rental property. Teachers (and perhaps other types of employees) with unreimbursed employee expenses may be able to properly claim the amounts as charitable contributions so long as the employer is a qualifying §501(c)(3) organization and the rules for charitable contributions are otherwise met for that amount.
In addition, a highly effective strategy for clients with substantial unreimbursed employee expenses involves negotiating with the employer to simply reduce wages by the amount of the expenses and either pay them directly for the employee, or reimburse the employee for such expenses through an accountable plan.
In addition, legal fees incurred in connection with taxable settlements are treated as miscellaneous itemized deductions subject to the 2% floor unless the legal fees are incurred to obtain a settlement arising from unlawful discrimination. Legal fees association with unlawful discrimination settlements are deductible as an income adjustment under §IRC §62(a)(20). If a settlement can be structured to provide for legal fee reimbursement, such a strategy can eliminate an AMT limitation on legal fees. The reimbursement of nondeductible expenses does not constitute income.