# 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.

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.

The AMT items that were talked about in Part 1 of this wrap-up generally were the bigger ones that can, depending on a taxpayer’s situation, present immediate year-end Alternative Minimum Tax savings opportunities. But the other items that were discussed in this 10-week series also are important in making sure the least amount of AMT is paid. Here is a brief recap of these other items, with references to the amtblog.com articles in which each appeared.

Investments: Private Activity Bonds – an individual investing in tax-exempt municipal bonds can receive an unpleasant surprise when he discovers that AMT has to be paid on the interest income from a certain type of municipal bond. See the December 18th article posted on amtblog.com.

Miscellaneous Itemized Deductions – business or investment-related expenses may be deductible under the Regular Tax, but they are not for the AMT. Several planning ideas on how to minimize this impact are presented. See the November 14th article posted on amtblog.com.

Limitation on Itemized Deductions: AMT Adjustment – when a taxpayer is in the AMT, the limitations that apply to itemized deductions are calculated differently from the limitations that apply for the Regular Tax. See the November 25th article posted on amtblog.com.

State Income Tax Refunds: AMT Adjustment – because of the different AMT treatment of state and local tax deductions, any adjustment to these deductions – for example, a refund of overpaid state taxes which generally is treated as income when received – is itself then given different treatment for the AMT. See the November 29th article posted on amtblog.com.

Standard Deduction – a taxpayer is allowed no standard deduction in calculating the AMT. An interesting planning idea here could mean that an AMT taxpayer might be better off not claiming the standard deduction at all. For a discussion of this opportunity see the November 18th article posted on amtblog.com.

Personal Exemptions – similar to the standard deduction, a taxpayer is allowed no deduction for personal exemptions in calculating the AMT. Not a whole lot can be done here, but there always are at least a few planning ideas. See the November 22nd article posted on amtblog.com.

The AMT Exemption, also known as “the annual patch” – the AMT Exemption amount is set annually by Congress. This is a prescribed amount by which a taxpayer’s Alternative Minimum Taxable Income must exceed his Regular Tax taxable income before the AMT itself is triggered. If Congress were to fail to adjust this exemption amount, 24 million new taxpayers would be pulled into the AMT, in addition to the four-plus million already stuck there. See the December 21st article posted on amtblog.com. Also, pay careful attention to the news we will be seeing on this in the near future as we anxiously await Congress’ fix on this again for 2010.

Good luck with your AMT planning. Hopefully each of these articles provided a simplified explanation along with a few 2009 Alternative Minimum Tax savings ideas. Soon we’ll be working on 2010!

Municipal bonds, or “muni bonds” as they are commonly referred to, offer favorable tax treatment in that the interest earned on them is not subject to tax. This tax-free yield can make them an attractive investment. If an investor is not careful, however, the AMT can apply to make certain muni bonds fully taxable. Unfortunately, many taxpayers discover this only after making the investment.

The general exemption from tax on muni bonds applies only for purposes of the Regular Tax. For purposes of the Alternative Minimum Tax, municipal bonds are divided into two categories – those used solely for public purposes, and those used to support private activities. The latter are called “private activity bonds.”

There are a number of different types of private activity bonds. Here are the descriptions found on the web site of the Municipal Securities Rulemaking Board (MSRB) – the organization that regulates brokers who deal in municipal securities:

Exempt facility bonds – Private activity bonds issued to finance various types of facilities owned or used by private entities, including airports, docks and certain other transportation-related facilities; water, sewer and certain other local utility facilities; solid and hazardous waste disposal facilities; certain residential rental projects, including multi-family housing revenue bonds), and certain other types of facilities. Enterprise zone bonds are also considered exempt facility bonds.

Qualified mortgage bonds – Private activity bonds issued to fund mortgage loans to finance owner-occupied residential property.

Qualified redevelopment bonds – Private activity bonds issued to finance certain acquisition, clearance, rehabilitation and relocation activities for redevelopment purposes by a governmental entity in designated blighted areas.

Qualified small issue bonds – Private activity bonds issued to finance manufacturing facilities in an amount up to $1 million, or higher in certain situations.

Qualified student loan bonds – Private activity bonds issued to finance student loans for attendance at higher education institutions.

Qualified veterans’ mortgage bonds – Private activity bonds issued to fund mortgage loans to finance owner-occupied residential property for veterans.

The main problem with private activity bonds is that the yield the taxpayer earns can be significantly less that what he anticipated at the time he made the investment. For example, assume a taxpayer buys a muni bond paying 4% interest. For a tax-free yield this is a pretty good return. Suppose, however, that this is a private activity bond, and that the taxpayer discovers he is stuck in the AMT. In this case the yield is something less than 3% (4% minus the AMT in the 28% bracket makes the actual yield only 2.88%). Perhaps as an investment this yield isn’t so attractive any more.

The key, as with all planning, simply is to do a little work in advance. The prospectus on any individual bond has to state if it is a private activity bond. For a muni bond mutual fund, the prospectus would be required to tell the investor if investing in private activity bonds is contemplated by the fund.

The AMT is a yield-killer. A little time spent reading or at least inquiring can go a long way towards protecting that precious yield!