K-1 / All other AMT Items

I Am an Investor – Does the AMT Apply to Me?

Friday, March 4th, 2011 | Print This Post | Email This Post

Every taxpayer with an investment portfolio of any size definitely needs to be concerned about the Alternative Minimum Tax. Certain types of investments, and the income earned on those investments, are likely to trigger the AMT. Most investors also have expenses associated with managing these portfolios, and certain of these expenses also can have an AMT impact.

It should be noted that only investments outside of qualified retirement plans – e.g., those investments not in a 401(k), an IRA or an employer’s retirement plan – are affected by the AMT, so it is these investments that are the focus of this article.

Investment income

Municipal bonds, in particular Private Activity Bonds

Interest earned on municipal bonds is exempt from the Regular Tax. For the Alternative Minimum Tax, however, certain municipal bonds – those labeled “private activity bonds”- are subject to tax. These types of bonds are used to support “private activities,” an example of which would be a local government’s development of an industrial park as an inducement for companies to locate in the area.

The concern to the investor is the negative impact that being subject to the AMT has on the bond’s effective yield. For example, a municipal bond fund in today’s market may be yielding in excess of 4 percent, but if private activity bonds are a part of that fund’s portfolio, more than a quarter of the yield on this part can be lost due to the AMT. That 4 percent quickly drops to a net-after-tax 3 percent yield!

Partnership investments

For an individual investing in a partnership, after the close of the year a tax form known as a “K-1” will be received. Because the partnership is a pass-through entity for tax purposes, this form tells each partner what income or losses to report on his or her individual tax return.

On the Form K-1 there also is a box labeled “Alternative Minimum Tax (AMT) Items.” If the partnership itself has any AMT items, they pass through and are reported by the individual partners just as the income or losses are. It is fairly common for investment partnerships to have activities that generate AMT items, so investors should consider inquiring about this when initially evaluating the investment. Here again, the anticipated yield can be reduced significantly if the AMT has to be paid.

Capital gains

Long-term capital gains are a bit of a sleeper issue with regard to the Alternative Minimum Tax. Although officially they are taxed at the same tax rate for purposes of the AMT as they are for the Regular Tax (currently 15 percent), and they are not a specifically-identified AMT item, nonetheless they can have a significant impact on an individual’s Alternative Minimum Tax. The reason for this is the fact that, as taxable income increases, the AMT exemption amount is gradually phased out. Since capital gains are included in taxable income, that 15 percent Regular Tax rate easily creeps closer to a 20 percent rate when figuring the AMT. This is especially important for those folks already in the phaseout income range ($150,000 to $440,000 for marrieds filing jointly; varies by filing status).

Investment expenses

Investment interest expense

If money is borrowed for the purpose of making investments, in general the interest paid on the debt is computed the same for the Alternative Minimum Tax as it is for the Regular Tax. There are two exceptions, however. One is if home equity indebtedness is used to acquire investment property. This type of interest is first disallowed for the AMT because it is not considered “qualified residence interest,” but when used for investing it generally is considered an allowable deduction for the AMT. The other exception is for interest on debt the proceeds of which were used to acquire private activity bonds. Because this interest is disallowed for purposes of the Regular Tax under the rules that disallow interest if loan proceeds are used to acquire municipal bonds, the interest expense related to the private activity bonds is an allowable deductible for the AMT.

Investment interest income

Investment interest expense is an allowable deduction, but only to the extent the taxpayer has investment interest income. For purposes of the AMT, investment income is computed somewhat differently than it is for the Regular Tax. For example, if an individual has private activity bond interest, this is included in AMT investment income because it is taxable for the AMT. Another example applies to taxpayers who have rental properties, where the Regular Tax-AMT differences in computing depreciation will result in a difference in investment income, thus affecting the amount of investment interest expense that may be deducted.

Other investment expenses

Investment-related expenses such as fees paid to an investment advisor, trust fees, safe-deposit box fees, etc. and any other expenses incurred in deriving income may be deducted for the Regular Tax, subject to certain limitations that apply. The AMT allows no deduction for these expenses, however, so this item may factor into an individual’s Alternative Minimum Tax computation.

Summary

Taxpayers with an investment portfolio easily can find themselves caught in a number of traps set by the Alternative Minimum Tax. But as the individual has total control over the investments made, these traps generally can be avoided with a little advance planning. For investors currently stuck in the AMT, a review of the items triggering this tax will allow the individual to consider rearranging the portfolio to lessen this AMT impact. The thing always to keep in mind is the simple fact that it is only the after tax yield that ends up in the individual investor’s bank account!

Posted in AMT Planning in General, Capital gains & Dividends, Investment Interest Expense, Investor, K-1 / All other AMT Items, Misc Deductions 2-percent Floor, Private Activity Bonds, Type of Taxpayer | No Comments »

Top 10 Traps Set by the AMT

Saturday, April 10th, 2010 | Print This Post | Email This Post

Of the nearly 30 different items that can cause taxpayers to fall into the AMT, a few are much more common than others. Here is a quick look at the “top ten” list of those that snare the most Alternative Minimum Taxpayers.

# 1 – Personal exemptions

For the Regular Tax, every taxpayer is entitled to a personal exemption deduction for himself, and his spouse and/or other dependents. Since the AMT denies any deduction for personal exemptions, this is the single item affecting almost every individual paying the Alternative Minimum Tax.

# 2 – State and local tax deduction

This item, which consists of property taxes, state and local income taxes, and sales taxes, is only slightly behind personal exemptions in terms of the number of AMT payers affected. The reasons for this are the relatively heavy burden of state and local taxes as well as the fact that the AMT disallows every dollar of this deduction.

# 3 -Capital gains

This is not specifically listed as an AMT item, but the impact of capital gains on an individual’s Alternative Minimum Tax can be significant. At levels of taxable income where most AMT payers find themselves, an additional $100 of capital gains could add up to $7 of AMT being paid on top of the $15 imposed by the Regular Tax capital gains bracket.

# 4 – Miscellaneous Itemized Deductions

A taxpayer’s employee business or investment-related expenses may be deductible under the Regular Tax, but they are not for the AMT. This affects nearly a third of all AMT payers.

# 5 – Depreciation

Business owners and investors with rental property are allowed depreciation deductions for the property used in these activities. The AMT disallows a portion of the depreciation deduction that otherwise may be taken.

# 6 – Passive activity losses

Many investment activities are considered “passive” for tax purposes. An example is a taxpayer who acquires an interest in an investment partnership. As such, losses from these investments are limited in how they may be deducted for purposes of the Regular Tax. The AMT imposes even further limitations on the use of these losses.

# 7 – Private activity bond interest

An individual investing in tax-exempt municipal bonds may receive an unpleasant surprise when he discovers that Alternative Minimum Tax has to be paid on the interest income from a certain type of municipal bond – the so-called private activity bond. While there may be an increase in before-tax yield from this type of bond, the after-AMT results can be very disappointing.

# 8 – Standard deduction

A taxpayer is allowed no standard deduction in computing the AMT. A valuable planning idea here could mean that an AMT taxpayer might be better off not claiming the standard deduction at all.

# 9 – Medical and dental expenses

For purposes of the Regular Tax, individuals are allowed a deduction for medical and dental expenses, to the extent these expenses exceed 7.5% of Adjusted Gross Income. The AMT limits this deduction even further by instead imposing an excess-of-10% requirement.

#10 – Limitations on investment losses

In addition to the limitation on the use of passive activity losses as discussed above, there are other investment activities, not falling under the passive rules, the losses from which still will be limited for purposes of the Regular Tax. Again, the AMT places even further limitations on the use of these losses.

Conclusion

In addition to this top ten list, there are nearly 20 other individual items waiting to trip up the AMT payer. The individual items that catch any particular taxpayer are shown on that individual’s Form 6251 that is attached to his tax return. It is important to note, however, that planning opportunities exist that can lessen the impact of each and every one of these. Check these out at AMTIndividual.com.

Posted in Capital gains & Dividends, Depreciation & Disposition of Property, K-1 / All other AMT Items, Medical And Dental, Misc Deductions 2-percent Floor, Personal Exemptions, Private Activity Bonds, Standard Deduction, State Income & Other Taxes | No Comments »

Alternative Minimum Tax Impact from Investing Activities

Sunday, March 14th, 2010 | Print This Post | Email This Post

Income that is earned from investments is a significant factor in the amount of Alternative Minimum Tax an individual pays. Certain types of investment income (dividends, capital gains, certain interest, e.g.) as well as the amount of this income in relation to the taxpayer’s other income, all factor into the AMT formula. A taxpayer usually has much more control over investment income than he does his salary, for example, making this source of income much more important from an Alternative Minimum Tax planning point of view. In general, an investment portfolio can be changed any time a taxpayer finds it advantageous to do so.

Discussed below are a few key items associated with investing activities, and the AMT planning opportunities that may exist.

Dividends and capital gains

Most dividends on common stocks are “qualifying,” and, thus, are eligible for a lower tax rate than “ordinary income,” which consists of things such as salaries and wages, interest income, rental income, and the like. Similarly, a capital gain that qualifies as a “long-term” capital gain also is eligible for this lower tax rate. As discussed in a recent article on amtblog.com, even though the tax rate on dividends and capital gains is the same for both the Regular Tax and the AMT, the effect on a taxpayer’s exemption amount can mean that these items of investment income are the reason a taxpayer is paying the AMT.

Planning strategy – use a model such as that available on AMTIndividual.com to determine the real tax rate being paid on dividends and capital gains. For maximum returns, investors should always consider after-tax yield when evaluating investment alternatives.

Tax-exempt bond interest

In general, municipal bond interest is exempt from Federal tax. However, certain muni bonds are designated “private activity” bonds, depending on how the proceeds of the bond issuance are used. Interest from private activity bonds continues to be exempt for the Regular Tax, but it is fully taxable for the AMT, with the result that the after-tax yield is significantly less than what the taxpayer originally thought he was earning. Note that, in order to boost yields, certain muni bond funds may allocate a portion of their portfolios to private activity bonds.

Planning strategy – Again, a taxpayer always should be considering after-tax yield in evaluating investments. An AMT payer generally should not be holding private activity bonds. If the investment is in mutual fund form, there are plenty of muni bond funds available that do not invest in private activity bonds.

Partnerships and other “pass-through” investments

In many cases partnerships themselves will have AMT items, but since a partnership “passes through” these items, it is the individual partner who ends up paying the AMT. For example, a real estate partnership may use a depreciation method that is allowable for the Regular Tax but is not allowable for the AMT. This difference in depreciation methods is an AMT item that will be reported to the partner on the Form K-1 he receives from the partnership, which, in turn, must be reported on the partner’s own AMT schedule, the Form 6251.

Note that this same pass-through treatment results in the case of S corporations, LLCs, and certain estates and trusts.

Planning strategy – Before investing in a partnership, an individual should inquire about AMT items that the partnership may generate. Once invested, it generally is too late to do anything about them.

Conclusion

While the old maxim that taxes should not determine an investment strategy is true, nevertheless an investor who is stuck in the AMT may be earning a significantly lower after-tax yield on his investments than he realizes. Remember that it is only after-tax income that an investor actually gets to keep; ignoring taxes, especially the AMT, is unwise.

Posted in AMT Planning in General, Capital gains & Dividends, K-1 / All other AMT Items, Private Activity Bonds | No Comments »

Passive Activities

Saturday, February 6th, 2010 | Print This Post | Email This Post

One of every seven taxpayers subject to the Alternative Minimum Tax is paying it, at least in part, because of what is known in the tax law as a passive activity. A passive activity is the tax characterization of a certain type of investment, and it may be possible for a taxpayer to reduce his AMT by paying attention to the investments in his portfolio that are triggering this item.

In general, a passive activity is either: 1) a trade or business in which the taxpayer did not materially participate; or 2) an investment involving rental real estate. “Material participation” means active involvement in the operations of the business on a regular, continuous and substantial basis. A typical passive activity is an investment partnership in which the taxpayer is a passive investor, not involved in the day-to-day management.

The passive activity rules were enacted as a way to curtail the use of tax shelters, where individual investors had ownership interests in partnerships that were generating tax losses that the individuals reported in their tax returns. Before the passive activity rules, these investors were allowed to offset other income, like dividends, interest, and salaries and wages, with these losses.

Passive activity losses are very limited in how that may be used against other income for purposes of the Regular Tax. If they cannot be used in the year they are first generated, the losses are carried forward to a future year when they can be used against income generated from the passive activities. In many cases this is the year the taxpayer exits the activity.

For purposes of the Alternative Minimum Tax, these same limitations apply, but the difference is that there also may be AMT items included within the computation of the passive activity loss itself. One common example is depreciation, whether the activity is rental property or a trade or business. For purposes of computing the amount of AMT loss that may be used against AMT passive income, whether in the current year or to be carried forward to be used in a future year, AMT adjustments like depreciation must be taken into account.

As an example of how this works, assume a taxpayer is a partner in a partnership and the Schedule K-1 the taxpayer receives shows the following:

- a Regular Tax passive activity loss of $2,500
- a depreciation adjustment of $500 (less depreciation allowed for the AMT)
- an adjustment of $250 to the gain from sale of property (less gain for the AMT)

In this case the taxpayer’s passive activity loss for Alternative Minimum Tax purposes is $2,250. It is important for the taxpayer to keep records of this difference in order to be able to properly compute his Regular Tax and his AMT in the years the loss is utilized, particularly in view of the impact it could have on his overall AMT planning.

Note – the taxpayer must be careful to have the AMT adjustments going in the right direction. In the example above, one adjustment decreased the loss while the other increased the loss. See the articles on amtblog.com on these two common passive activity AMT items, Depreciation, and Disposition of Business or Rental Property, that appeared on the blog on January 20th and January 24th, respectively.

Posted in K-1 / All other AMT Items | 2 Comments »