FAQs on the Alternative Minimum Tax

Each year, more and more taxpayers discover, to their dismay that they are subject to the alternative minimum tax (AMT), which knocks out a lot of exemptions, deductions, and credits they may have gotten used to when doing their regular income taxes. Here are the answers to common questions about the dreaded AMT, starting with the latest news about a last-minute change that protects nearly 20 million taxpayers from falling victim to the AMT when they file their 2007 returns.

• How did Congress change the Alternative Minimum Tax for 2007?
• Will the 2007 filing season be delayed?
• Why does the AMT exist?
• What is the Alternative Minimum Tax?
• Why are middle-class folks being hit with the AMT?
• Why would I have to pay the AMT?
• What happens to my tax credits?
• How can I plan ahead for the AMT?

How did Congress change the AMT for 2007?

At the last minute, Congress approved a long-expected "patch" for the AMT. The patch increases the AMT exemption, which is basically a standard deduction for taxpayers hit by the alternative minimum tax. Without the patch, the 2007 exemptions would have fallen from "patched" 2006 levels—$42,500 for single taxpayers, for example, and $62,550 for married taxpayers filing jointly—to pre-patch levels of $33,750 for singles and $45,000 for married couples. The stunted exemptions would have pushed an estimated 19 or 20 million taxpayers into the grasp of the AMT—boosting their tax bills by an average of more than $2,000 each. As a group, the taxpayers would have paid an extra $50 billion in taxes. The patch approved by Congress and signed into law by President Bush, prevents that from happening.

Under the new law, the 2007 exemption amounts are:

The latest patch is a one-year-only fix...which means Congress will have to address this issue again in 2008.

Will the 2007 filing season be delayed?

In early December, while waiting for Congress to okay the AMT patch, the IRS warned that failure to do so promptly could delay the filing season by as many as eight weeks and delay refunds to tens of millions of taxpayers. Once the new rules were signed into law, however, the agency said the delay would likely affect only three to four million taxpayers. Because of the time it takes the IRS to reprogram its computers, the agency says it will not be able to process any returns that include certain forms until February 11 (processing normally begins in mid-January).

The delay will impact taxpayers filing any of the following forms:

• Form 8863, "Education Credits"
• Form 5695, "Residential Energy Credits"
• Form 1040A Schedule 2, "Child and Dependent Care Expenses"
• Form 8396, "Mortgage Interest Credit"
• Form 8859, "District of Columbia First-Time Homebuyer Credit."

TurboTax is working closely with the IRS to ensure that delays in legislation this year, including the AMT patch that was just signed into law December 26, 2007, have as little impact on you as possible—and you get your refund easily and quickly. Here's how TurboTax makes it easier on you:

• Start your tax return with TurboTax anytime and eFile beginning January 4.
• TurboTax will automatically update with the new changes to the tax code. We'll ensure that all the latest forms are filled out for you before your return is submitted to the IRS.

Why does the AMT exist?

In 1969, Congress noticed that 155 people with a high income were legally using so many deductions and other tax breaks that they were paying much less in tax than lower-income people who had few deductions. So Congress instituted the AMT with the aim of making the tax system fairer. But since the AMT was never indexed to inflation—as the regular income tax is—each year, more and more middle-income taxpayers are snared by a tax originally targeted at the rich. The "patch" discussed above is Congress’s attempt to slow down the expansion of the AMT to taxpayers to whom it was never intended to apply.

What Is the Alternative Minimum Tax?

The AMT is a parallel tax system that operates in the shadow of the regular tax, expanding the amount of income that is taxed by adding items that are tax-free under the regular tax system and disallowing many deductions.

• To figure out whether you owe any additional tax under the Alternative Minimum Tax system, you need to fill out Form 6251.
• If the tax calculated on Form 6251 is higher than that calculated on your regular tax return, you have to pay the difference as AMT. It can result in you paying hundreds or thousands of dollars in additional taxes.

Why Are Middle-Class Folks Being Hit with the AMT?

In 1987, one year after the last major overhaul of the Alternative Minimum Tax system, only one tenth of one percent of all returns had to pay the Alternative Minimum Tax.

Today, the Alternative Minimum Tax is no longer just for high-income individuals. Now, many middle-income Americans are paying the Alternative Minimum Tax or having their tax credits limited by its hidden effects.

The Treasury Department expects that more and more people will be paying the AMT over the next few years.

In fact, in 2010, the percentage of married couples with children paying AMT in all income brackets is projected to be 39 percent.

More people will be subject to the AMT in the future largely because the AMT exemption amounts have not been indexed for inflation. Regular tax brackets and regular tax personal exemptions are indexed for inflation each year to prevent bracket creep, an automatic upward shift in the marginal income tax bracket through inflation. More and more people will be subject to the AMT, not because they are making more money in real dollars, but just through the effects of cost-of-living adjustments in their wage income.

For each of the last few years, Congress has approved temporary patches to increase the amount of income exempt from the AMT. But these short-term solutions generally protect new taxpayers from being hit by the AMT. If you have paid it in past years, it's likely that you will continue to pay it. For 2007, Congress raised the AMT exemption to $66,250 for joint filers and surviving spouses; $44,350 for individuals and $33,125 for married couples filing separately. The last-minute—but long-expected—patch protects 19 to 20 million new taxpayers from being affected by the AMT on their 2007 returns.

Without the patch, the government estimated that more than 80% of taxpayers with incomes between $100,000 and $200,000 would have owed the AMT on their 2007 returns.

Why Would I Have to Pay the AMT?

The simplest way to see why you are paying the AMT, or how close you came to paying it, is to look at your Form 6251 from last year.

• Compare the Tentative Minimum Tax to your regular tax (Tentative Minimum Tax should be the line above your regular tax) to see how close you were to paying the AMT.
• Look for positive entries on lines 1 through 26, which indicate increases to your taxable income for the purposes of the AMT. For instance, you have to put various items back into your income, adding such items as your standard deduction, personal exemptions, home equity mortgage interest, miscellaneous deductions such as employee business expenses, and incentive stock options.

How Can I Avoid the AMT?

One of the best things that can be said about the AMT is that Congress was successful in making it difficult to get around this tax. To avoid the AMT, you need to understand how the AMT differs from the regular tax system.

We'll walk through form 6251, line by line, looking at the way the AMT handles different deductions and expenses, and wherever we see a tax-planning opportunity, we will suggest how to lessen the impact of the AMT.

Line 1, Standard Deduction: If you itemize, this line is your Adjusted Gross Income (AGI) minus your itemized deductions (some of which are added back in on the following lines). If, on the other hand, you take the standard deduction instead, this line is solely your AGI; you can't take any part of the standard deduction when calculating the AMT. So, if you took the standard deduction on your regular return, it is added back into your income here.

Line 2, Medical Expenses: If you itemize deductions, medical deductions are only allowed to the extent that they exceed 10 percent of adjusted gross income, rather than 7.5 percent under the regular tax system.
Suggestion: See if your employer has a pre-tax medical deduction plan or cafeteria plan. If you pay medical expenses on a pre-tax basis, they are no longer included in taxable wages or deductible as itemized deductions. This will help with both the AMT and your regular tax.

Line 3, Taxes: In calculating the AMT, you cannot take itemized deductions for state and local income tax, real estate taxes, and personal property taxes, even though these are deductible on your regular return.

Suggestion 1: In a year that you have to pay the AMT, don't bother prepaying real estate or fourth-quarter state estimated tax payments in December. You get no benefit from paying these taxes in a year that you are subject to the AMT.

Suggestion 2: Real estate tax and personal property taxes are not deductible for AMT if they are part of itemized deductions. Taxes deductible on a business schedule (Schedule C), rental schedule (Schedule E), or farm schedule (Schedule F or Form 4835) are allowed for the AMT.

• Perhaps you can qualify for a home office, which would allow you to deduct part of your home real estate tax on Schedule C.
• If you have a farm operation and use your car in your work, you could deduct the personal property tax on the car on Schedule F.
• If you have vacant land on which you are paying real estate tax, you could turn it into a farm rental and deduct the taxes on Form 4835.

Line 4, Home Equity Interest: Home mortgage interest claimed as an itemized deduction is only deductible for the AMT if the loan was used to buy, build or improve your home. For regular tax purposes, interest on home equity mortgages up to $100,000 is deductible, even if the proceeds are used for personal purposes, such as buying a car or paying off credit card debt.

Suggestion: If you are subject to the AMT, there is no advantage to using your home equity line of credit to buy a car, because the interest will not be deductible. You may be able to get a lower interest rate from a regular car loan. If the car is used in your business, you may be able to write off some of your auto loan interest as a business expense on Schedule C.

Line 5, Miscellaneous Itemized Deductions: Miscellaneous itemized deductions are not deductible for AMT purposes. Often generated by employee business expenses, these itemized deductions can save you a lot of money on your regular return. If so, when the AMT puts them back into your taxable income, you could face a big problem.

Suggestion 1: Employee business expenses (Form 2106) are incurred by employees, not self-employed individuals. These work-related expenses were not reimbursed in full by the employer. These expenses become miscellaneous deductions on Schedule A, Itemized Deductions, and can only be deducted to the extent that all miscellaneous deductions exceed 2% of your adjusted gross income. Only the excess amount can be deducted. If you are in this situation, ask your employer to start reimbursing you for your business expenses.

If your employer has a non-accountable business expense plan (explained below), encourage him or her to adopt an accountable plan.

• In a non-accountable plan, your employer gives you an expense advance check and you are not required to keep records of your purchases.
• The advance is included in your income, and you take your expenses as miscellaneous itemized deductions.
• In the AMT system, you are taxed on the expense advance, but can't take a deduction for the expenses.

To avoid this situation, encourage your employer to change to an accountable plan. With this plan, you turn in your receipts to your employer and you must refund any expense advance not used. Because you are not taxed on the advance and you do not take a deduction for the expenses, you avoid being hit by AMT rules.

Suggestion 2: If you have employee business expenses that your employer refuses to reimburse, and you know that these expenses are causing you to pay the AMT, consider negotiating with your employer. You may be better off by having the employer pay some of these expenses in exchange for a lower salary. Your employer will save on payroll taxes, workman's compensation insurance, and in some cases liability insurance premiums, and you will reduce your taxable income and possibly avoid the AMT altogether.

Line 7, State Tax Refund: If you have a taxable state tax refund on your regular tax return, it does not count as taxable income for AMT purposes because you do not receive a corresponding deduction for state tax.

Line 8, Investment Interest: The investment interest deduction may be different for AMT purposes because it depends on whether you have taxable private activity bond interest (see line 11). If you do, you may have an additional deduction for investment interest.

Line 9, Depletion: You can calculate depletion from mining, oil, gas, timber or other similar activities for regular tax purposes using either the cost or percentage depletion method. For AMT, only the cost method is allowed.

Suggestion: If this line is generating AMT on your tax return, consider electing the cost method of depletion.

Line 11: Tax-exempt Interest: This line commonly has an entry, but the amount is usually not large enough to generate AMT on its own. Some tax-exempt interest, namely from private activity bonds, is not tax-exempt for AMT purposes. A private activity bond is a state or local bond issued to provide funds for private, nongovernmental activities such as building a sports stadium, industrial development, student loan financing, or low-income housing. These bonds are often issued by states, counties, or cities and are tax-exempt for regular federal tax, but not for the AMT. If you invest in mutual funds, the year-end literature often contains information about the amount or percentage of the distributions from private activity bonds. This amount is entered on Line 11 to show the income as taxable for AMT purposes.

Suggestion: If you are subject to the AMT, invest in tax-exempt bonds that are not private activity bonds. Many mutual fund companies have two listings of state bond funds, one that contains private activity bonds, and one that doesn't. Read the literature carefully.

Line 12, Section 1202 Exclusion: You can exclude from your income some portion of the gain on the sale of qualified small business stock held more than five years. The gain on the sale of this stock is 50 percent excludable for regular tax purposes, but 7 percent of the excluded gain is added back for AMT purposes.

Suggestion: In the year that you sell qualified small business stock, try to eliminate or reduce as many other AMT adjustments as possible to get the maximum gain exclusion on the sale of the stock.

Line 13, Incentive Stock Options: This line is another common problem for people affected by the AMT. If you exercise an incentive stock option (ISO) but do not sell the stock in the year of exercise, the transaction is not taxable that year for regular tax purposes.

However, the difference between the exercise price and the fair market value of the stock on the day of the exercise is an adjustment for AMT and appears on Line 13. For many people, this adjustment can be a very large number. Essentially, you are going to be taxed on a hypothetical profit (what you might have made if you sold the stock on the day you bought it.)

Example:

You exercise incentive stock options (ISOs) to purchase 100 shares of stock at $3 per share and you decide to hold the stock as a long-term investment. The stock is trading at $33 per share on the day of the exercise. Line 13 on your Form 6251 is $3000 (100 shares x ($33-$3 per share)).

Your basis in this stock is now $300 ($3 x 100) for regular tax purposes, but $3300 ($33 x 100) for AMT purposes. When you later sell the stock, you will have an entry on Line 16, Disposition of Property Difference, to account for the difference in your tax basis for regular and AMT purposes.

Suggestion 1: If you exercise the ISOs in the previous example at $33 and the stock falls before the end of the current year, you can sell the stock and avoid the AMT. If the stock fell to $25 during the year of the exercise, you would be subject to regular tax on only $22 per share ($25-$3) and not be subject to the AMT adjustment at all.

Suggestion 2: When you exercise ISOs, always use tax planning software to forecast the tax consequences. You may need to sell some of the stock in the year of the exercise to pay the tax due.

Line 14, Estates or Trusts: This line contains differences between AMT and regular tax deductions from estates or trusts. Decisions by the administrators of the estate or trust may be beyond your control.

Line 15, Electing Large Partnerships: An entry on this line comes from a partnership in which you are a partner. Other than disposing of the investment, which would have other tax ramifications, there is probably nothing you can do about an entry on this line.

Line 16, Disposition of Property Difference: The tax basis in assets that you sold may be different for regular and AMT purposes depending on the depreciation method you chose (see Line 17), or on your incentive stock options (see Line 13).

Line 17, Post-1986 Depreciation: On this line, you enter the depreciation difference for regular and AMT purposes. For AMT purposes, you generally must depreciate (deduct) business assets over a longer period of time than you can for regular tax purposes. This creates a difference between regular tax depreciation and AMT depreciation. This is an entry that does self-correct. By the time the asset is completely written off, you have received the same deduction for both regular and AMT purposes.

Suggestion: If you have an entry on this line, consider electing a slower depreciation method for your business assets, which could eliminate the AMT adjustment.

Line 18, Passive Activities: This line contains the differences between AMT and regular tax deductions for passive activities. This line usually relates to a difference in depreciation methods for rentals, partnerships, or S Corporations.

Suggestion: If the adjustment is from a rental property, consider using slower depreciation methods for regular tax purposes to eliminate an entry on this line. If the adjustment is from a partnership or S Corporation, the depreciation methods are selected at the entity level and there is probably nothing you can do.

Line 19, Loss Limitations: You may have AMT or regular tax differences due to passive investments in partnerships or S Corporations. Depending on your percentage of ownership, you may discuss with the management of these investments any items that are generating AMT on your tax return to see if the AMT impact can be lessened in future years.

Line 20, Circulation expenditures: This line relates to the difference between how newspaper or magazine circulation expenditures are deducted under both tax systems.

Suggestion: If you have an entry on this line, consider making an election under Internal Revenue Code (IRC) 59(e) to amortize these expenses over three years for regular tax purposes. This will eliminate the entry on this line for AMT purposes.

Line 21, Long-Term Contracts: Long-term construction contractors are generally required to use the percentage of completion method of accounting for long-term contract revenue, rather than the completed-contract method. This is a timing difference that will reverse in later years.

Line 22, Mining Costs: Mining exploration and development costs may also generate an AMT adjustment unless you make an IRC 59(e) election to write-off the costs over 10 years. Making the election eliminates an entry on this line.

Line 23, Research and Experimental Expenditures: This adjustment is related to a timing difference between deducting Research and Experimental Expenditures for regular and AMT purposes. You can eliminate this line entry if you make the IRC 59(e) election to deduct the costs over 10 years.

Line 24, Installment Sales: Installment sales of inventory items are not allowed for AMT purposes for sales entered into between August 16, 1986, and January 1, 1987. (Almost no one uses this line).

Line 25, Intangible Drilling Costs: This line relates to the difference in timing of the deductions for intangible drilling costs. You can make an election under IRC 59(e) to write off intangible drilling costs over 60 months for regular tax purposes, and eliminate an entry on this line.

Line 26, Other Adjustments: This line relates to any other income or deduction items that are affected by AMT differences, such as taxable IRA distributions, self-employed health insurance, IRA deductions, and other income-based calculations.

Also, in calculating the AMT you cannot take the deductions for personal exemptions. This is one of the reasons that married couples with children are strongly affected by the AMT. If you are a married couple with three children, you lose $17,000 ($3,400 x 5) in personal exemptions under the Alternative Minimum Tax system in 2007.

Having thrown so many items back into your income, you now get a small break. Your taxable income for AMT purposes is reduced by an exemption amount, which depends on your income and filing status. For 2007, the exemption amount for married couples filing joint is $66,250 and $44,350 for individuals. This exemption amount phases out as income increases.

Now you calculate the Tentative Minimum Tax. You compare this figure to the tax you calculated under the regular tax system on Form 1040.

The difference is the Alternative Minimum Tax.

You pay the Tentative Minimum Tax or the regular tax, whichever is higher.

What Happens to My Tax Credits?

If the calculation on Form 6251, Alternative Minimum Tax shows that your Tentative Minimum Tax is less than your regular tax, you don't owe any AMT, but you may still be affected by the AMT in other ways.

Business Credits

Because of the AMT, you may not be receiving all of your tax credits such as the Low-Income Housing or Work Opportunity Credits.

Your Tentative Minimum Tax limits these credits and other general business credits, because these credits cannot reduce the tax you pay below the Tentative Minimum Tax.

• If you have any of these credits, usually from a business entity or an investment, you should analyze lines 1-26 of Form 6251 to see what you can do to reduce your Tentative Minimum Tax and allow more credits.
• Any general business credit not allowed may be carried back two years and carried forward twenty years.

Credit for Paying the AMT

You get a tax credit for Alternative Minimum Tax paid in a prior year.

This credit, calculated on Form 8801, Credit for Prior Year Minimum Tax, calculates how much of the AMT was related to deferral items, which generate credit for future years, as opposed to exclusion items which are not deductible for AMT, and consequently are lost.

Certain items in Lines 2 through 26 of the Form 6251 are simply not deductible for AMT purposes, such as taxes, home equity mortgage interest, and miscellaneous deductions. Lines 2-5, 7-9, 11, and 12 are exclusion items. If you paid AMT based on entries on these lines, you will not receive a tax credit for AMT.

Other items create timing differences, such as depreciation differences between the two tax systems, and will generate a credit on Form 8801 and reduce your taxes in future years.

Lines 13 through 26 are deferral items. An AMT credit may be generated based on the reversal of the timing difference of these items. For example, AMT depreciation methods may be slower than those for the regular tax, but you will eventually receive the same deduction. To calculate and report your AMT credit you need to fill out Form 8801, Credit for Prior Year Minimum Tax — Individuals, Estates, and Trusts.

Beginning in 2007, taxpayers who incurred large AMT tax credit carryforwards due to the exercise of incentive stock options before the tech stock crash in 2000 and 2001 will be able to recover a major portion of their credits over the next six years. This year, they will be able to claim a refundable credit of at least $5,000 or 20% of their long-term unused minimum tax credit, whichever is higher. Any minimum tax credit that is a result of AMT paid in 2003 or earlier is included in the long-term unused tax credit.

To figure the refundable amount of your minimum tax credit, and the AMT refundable credit amount, apply the rules that follow under Long-term unused minimum tax credit, AMT refundable credit amount, and Credit refundable.

Long-term unused minimum tax credit. To figure the refundable amount of your minimum tax credit, you must first determine whether you have any "long-term unused minimum tax credit." Your long-term unused minimum tax credit is the amount of your minimum tax credit carryforward from 2003 (2003 Form 8801, line 26), reduced by the amount of any minimum tax credits you claimed for 2004, 2005, and 2006 (line 25 of your 2004, 2005, and 2006 Forms 8801).

AMT refundable credit amount.  After you figure your long-term unused minimum tax credit, you then must figure your "AMT refundable credit amount." Your AMT refundable credit amount is the greater of:

• 20% (.20) of your long-term unused minimum tax credit, or
• The lesser of:
  
  • $5,000, or
  • Your long-term unused minimum tax credit.

The AMT refundable credit amount is reduced if your adjusted gross income (AGI) exceeds certain threshold amounts based on your filing status. The AGI threshold amounts for 2007 are in the table that follows.

Your AMT refundable credit amount is reduced by 2% (.02) for every $2,500 ($1,250 if your filing status is married filing separately) that your AGI exceeds the threshold amount. Use your 2006 tax return and AGI (2006 Forms 1040, line 38, and 1040NR, line 36) as a guide in estimating your 2007 AGI.

For 2007, the AMT refundable credit amount is reduced if your AGI is more than the applicable amount in the second column of the following table and is eliminated if your AGI is more than the applicable amount in the third column.

Credit refundable.  The refundable amount of your credit is the amount by which your minimum tax credit for the year exceeds the amount your minimum tax credit would be without regard to the above rules.

Form 8801.  To claim the refundable and nonrefundable parts of this credit, use the 2007 Form 8801, Credit for Prior Year Minimum Tax—Individuals, Estates, and Trusts.

How Can I Plan Ahead for the AMT?

There are some things you can do to plan ahead for the Alternative Minimum Tax:

1. Use tax-planning software such as TurboTax during the year to minimize your overall tax liability.
2. Study Form 6251 each time you prepare your tax return to see how close you are to paying the AMT. Evaluate how close your Tentative Minimum Tax (line 33) was to your regular tax (line 34). For information on Form 6251, see the Instructions.
3. Check last year's return for any general business credits that are being carried forward. If there are some, they may be due to the Tentative Minimum Tax limit.
4. If you exercise stock options during the year, see Incentive Stock Options for guidance on how the timing of the subsequent sale of stock can affect your AMT liability.

Updated for tax year 2007