State Income & Other Taxes

Thinking of Buying a Home? Watch Out for the AMT “Bite”

Friday, March 9th, 2012 | Print This Post | Email This Post

Economists are saying the real estate market may finally be bottoming out. New construction activity is picking up, as are resales of existing homes. There remains a significant of foreclosure activity, but to a buyer this is just another opportunity. While in general the tax advantages of home ownership are well-known and well-publicized, little is actually known about the Alternative Minimum Tax implications of home ownership. Understanding this can make a significant difference to new homeowners because they may not end up getting the tax benefits that they think they will be receiving.

The costs of home ownership

Along with home ownership comes a mortgage, with monthly payments seemingly going on forever as well as an obligation to pay property taxes. While a small portion of the monthly mortgage payment will go towards paying done the principal of the loan, the largest part of each payment will be interest. This interest portion has tax implications, both for the Regular Tax as well as the AMT, as discussed below.

Real estate taxes are annual obligations that must be paid to state and local governments. Each taxing jurisdiction sets its own payment schedule – some are due annually while others may be semiannually or quarterly. One of the things new homeowners may experience is the lending bank requiring that property taxes be escrowed. In this case, each monthly mortgage payment includes an estimate of 1/12^th of the total property taxes due. The bank then holds these funds in escrow, and it is the bank that makes the actual payments to the taxing jurisdiction.

Mortgage interest

The good news is that interest paid on a mortgage used to acquire a home is fully deductible, both for the AMT as well as the Regular Tax. (There is a $1 million limitation on the debt for this purpose, but we’ll assume this is not a problem for the average reader.)

AMT problems arise, however, when a second mortgage or home equity line of credit is put on the home. While the interest on these loans similarly is deductible for the Regular Tax (for loans of up to $100,000), the Alternative Minimum Tax limits the deduction to loans the proceeds of which are used to make improvements to the residence. Thus, for example, if the line of credit is used to buy a new car, that interest is no longer deductible for the AMT.

Real estate taxes

Here is where the real “bite” is felt from the Alternative Minimum Tax. Property taxes, while fully deductible for the Regular Tax, are not deductible at all for purposes of the AMT. This is the reason property taxes, along with state income taxes, are the single largest item affecting the majority of Alternative Minimum Tax payers. In fact, nearly 95% of everyone stuck in the AMT is affected by this item alone.

Planning opportunities

Is it possible to own a home and not get stuck by the Alternative Minimum Tax? The answer is yes, depending of course on each individual’s situation. The key to this, however, is doing just a little planning for the AMT-triggering interest and taxes items.

Planning for interest – as discussed above, the primary mortgage on the house is not an AMT problem. If consideration is being given, however, to using the equity in the home for making other purchases such as the car example above, it could make more sense to look to a traditional auto loan instead of a home equity loan. A simple comparison of the after-tax cost of the interest needs to be made.

Planning for taxes – the key to minimizing the AMT impact from real estate taxes is to know whether you will be in the Alternative Minimum Tax this year or next year. If you can pay all or even a part of your real estate taxes in a year you are not in the AMT, you will get a tax benefit from the deduction, which could be a refund of up to 35 percent of the property tax bill. As an example, if you receive a tax bill in the fall and it is not due until January, you have total discretion to pay it in either year. If you already are in the AMT this year but do not expect to be until next year, simply wait until January to pay the bill. Note that if your taxes are escrowed you will need to talk with your banker about the timing of these payments.

Don’t let the joys of home ownership be soured by having the AMT take a surprise “bite” out of your investment in the home in the form of additional taxes you weren’t anticipating!

Posted in AMT Items, AMT Planning in General, Home Mortgage Interest, State Income & Other Taxes, Uncategorized | No Comments »

Alternative Minimum Tax Fails to Hit the Wealthy With any Real Impact

Sunday, February 12th, 2012 | Print This Post | Email This Post

Everyone knows the history of the Alternative Minimum Tax – its intended purpose was to ensure that the wealthy were paying at least something like what today is called their “fair share” of taxes. But as everyone also knows, its real impact has landed on the masses who are far from finding themselves in this wealthy category. How the AMT has failed in its purpose is easily seen by looking at the income tax return of someone who really can be considered “rich.”

Presidential campaign season

Once again (how does it come around so often?) we find ourselves in the throes of a Presidential campaign. Along with the many unpleasantries being exchanged by candidates is the challenge to release personal income tax returns. After much prodding, one candidate recently, but reluctantly, released his Form 1040, and this tax return shows that he in fact definitely is in the wealthy, even “super wealthy,” category.

Do the wealthy pay the AMT?

The positive news is that the answer to this question is “yes.” However, the not-so-good news is seeing the actual amount of Alternative Minimum Tax that this individual in fact is paying. In the two tax years that this presidential candidate has paid the AMT, the additional tax burden that resulted was barely over one percent of his income. Specifically, without the AMT his total Federal tax rate was 13.3% in 2010, and 14.3% in 2011. The AMT added 1.1% each year, for a whopping tax rate of 14.4% and 15.4%, respectively. And this is on over $20 million of income in each of the two years!

What are the Alternative Minimum Tax triggers at this level of income?

The items that are high on the list of every single AMT payer are the same ones that also hit the wealthy. These are both on the income side as well as on the deduction side, and they principally revolve around capital gains and itemized deductions, and for the itemized deductions in particular the deductions for state income taxes as well as for property taxes.

Capital gains

Without even looking at this individual’s tax return, as one quickly can conclude from the tax rates shown above, most of this individual’s income comes from long-term capital gains which are eligible to be taxed at the low 15% rate instead of ordinary income rates of 35%. These large capital gains cause two Alternative Minimum Tax problems – the obvious one is the loss of the AMT exemption because of the high level of taxable income. But the other is the effect of having to pay state income taxes on these capital gains as well as high property tax payments.

State income taxes

Most, if not all, states tax capital gains at the same rate as ordinary income. Thus, a large capital gain will carry with it the same state income tax burden as would the same amount of ordinary income. The larger an individual’s state income tax of course the greater his chances of being caught in the Alternative Minimum Tax. This same basic problem exists for the wealthy as it does for every other AMT payer.

Property taxes

Along with wealth comes the need to own homes – usually large ones and usually more than one. Accompanying this ownership privilege is the requirement to pay significant amounts of property taxes – surprisingly the wealthy get no break on their property taxes. Just like state income taxes, property taxes are one of the most common items for individuals who are stuck in the Alternative Minimum Tax.

What could this individual do to reduce his Alternative Minimum Tax?

There are no secrets here – the same actions that every AMT payer can take would help a wealthy individual reduce his Alternative Minimum Tax. For example, one is watching the timing of payment of state income taxes and property taxes at year-end. If a taxpayer is in the AMT one year but not the next, whether the individual is wealthy or not wealthy, trying to get the state tax deductions paid in the year he is not in the Alternative Minimum Tax will make a big difference. Also, if an individual has multiple homes, the opportunity to change his domicile to a state that doesn’t have income taxes – like Florida, for example – would save significant state income taxes and correspondingly reduce the individual’s AMT burden. The same Alternative Minimum Tax planning concepts apply to everybody!

Posted in AMT Items, AMT Planning in General, Capital gains & Dividends, State Income & Other Taxes | 2 Comments »

IRS Statistics Show the Alternative Minimum Tax Decreasing – What Gives?

Saturday, January 14th, 2012 | Print This Post | Email This Post

Periodically the IRS publishes what it calls its Statistics of Income Bulletin. This document reports data that has been compiled from all of the tax returns filed for the previous year, including data on the Alternative Minimum Tax. This year’s report shows that, for the first time after six straight years of the AMT increasing, the amount of AMT paid and the number of taxpayers paying it decreased from the previous year. Are we finally seeing some needed relief from this burden? Hardly; rather it is just another result of the terrible economy we find ourselves in.

Fall 2011 SOI Bulletin

The Fall 2011 Bulletin includes statistics for tax returns filed in 2010 for the tax year 2009. For this period a total of 142.5 million individual income tax returns were filed, 3.8 million of which were Alternative Minimum Tax payers paying a total of $22.6 billion of AMT. These figures represent a decline from the previous year, during which 3.9 million individuals paid the AMT in the total amount of $25.7 billion. For tax year 2009 the average AMT paid was $5,900, compared to $6,500 for the previous year.

Who are the AMT payers?

The Bulletin breaks down the makeup of AMT payers by level of adjusted gross income (AGI). Even with the decline, this data shows that the distribution stayed essentially the same as the prior year, with 24% of AMT payers being those in the $100-200,000 AGI range and the majority – 63% – being in the $200-500,000 range. So many of those well below what President Obama considers “the rich” are stuck paying this tax that originally was designed to hit only the true wealthy.

Why did the AMT burden drop?

The explanation for the decrease in number of AMT payers and total dollars of Alternative Minimum Tax paid is not the result of any change in our government’s tax policy, unfortunately, but rather is explained simply by the current economic downturn. Specifically, as incomes decrease individuals are having less of those items that trigger the AMT. This applies both on the deduction side of the Alternative Minimum Tax as well as on the income side.

- Itemized deductions, in particular the deduction for state and local taxes

The amount of itemized deductions taken by individuals decreased from 2008 to 2009. The one most important to Alternative Minimum Tax payers, the deduction for state and local income taxes and property taxes, itself decreased 7.5 percent. As all AMT payers know, the more state and local taxes paid, the greater the Alternative Minimum Tax burden. It follows logically, therefore, that lower taxes paid potentially means a lower AMT burden. This won’t necessarily apply to all taxpayers, particularly those whose state legislators saw fit to increase taxes such as Illinois, but in general this result follows.

- Capital gains and dividend income

Capital gains and dividends are taxed at the same low rate both for the Regular Tax as well as the Alternative Minimum Tax. However, the more of these items a taxpayer has the more the taxpayer’s AMT exemption will be phased out and the correspondingly higher his Alternative Minimum Tax burden will be. It follows, therefore, that the worse the stock market does, and the more that companies cut back on their dividends, the less that individuals will see this impact on their AMT exemptions. Again, this won’t necessarily apply across the board, but it generally explains the result.

What should AMT payers do?

Planning to minimize the Alternative Minimum Tax is the same regardless of any changes in a taxpayer’s individual position. If an individual was on the cusp and the current state of the economy dropped him out of the AMT, there are opportunities to time some of his income and deductions to take advantage of this. For example, folks not in the AMT may want to accelerate the deduction of property taxes to take advantage of the opportunity to get a Regular Tax benefit that is not available once back in the AMT. But caution needs to be exercised as a slight change in facts can throw the individual right back into the AMT again. So planning still is, and always will be, the key.

As taxpayers get ready to undertake preparation of their 2011 taxes, this information will be very useful in thinking about 2012 planning. Certainly the 3.8 million still stuck in the AMT need to do this, as well as the 100,000 that dropped out of the AMT last year.

Posted in AMT Exemption, AMT Items, AMT Planning in General, Capital gains & Dividends, State Income & Other Taxes | No Comments »

Year-End Tax Extenders – Where’s The Patch?

Sunday, December 11th, 2011 | Print This Post | Email This Post

Every year at about this time Congress starts thinking about what tax laws will expire on December 31, and what it really needs to be doing about these. Of the 65 various tax provisions that will expire, one of the big ones is the annual “Patch” for the Alternative Minimum Tax. Without the Patch, nearly 30 million new taxpayers will wake up on New Year’s Day with a lot more than the usual hangover, and the 4 million already in the AMT had better get their checkbooks out for the additional taxes they’ll owe. In addition to this one item, however, there are several other extenders that also can have a direct impact on AMT payers.

What is The Patch and what does it mean to AMT payers?

The Patch is the annual adjustment to the exemption amount allowed in computing each individual’s AMT. Using the married filing jointly example, the exemption for 2011 is $74,450. If the Patch is not enacted for 2012, this amount would drop to $45,000, meaning that the couple’s taxable income subject to the AMT would increase by $29,450 – the difference between these two numbers. This could mean an additional $8,000 in Alternative Minimum Tax due in 2012!

Personal tax credits allowed against the AMT

The tax law is replete with what are known as “tax credits.” A tax credit is distinguished from a tax deduction in that it is a direct reduction of your tax liability instead of a reduction of your taxable income in computing your tax liability. For example, if you are in the 26% AMT bracket a $100 tax deduction would save you $26 in taxes. Compare this with a $100 tax credit, which would reduce your taxes by the full $100. One example of a credit that a taxpayer might be eligible is that allowed for making certain energy-efficient improvements to one’s personal residence.

A significant number of tax credits are allowed only to individuals paying the Regular Tax, denying those stuck in the AMT a similar benefit. On occasion, however, Congress has seen fit to extend these benefits to AMT payers, but only for one year at a time. A number of these types of credits are on the tax extenders list.

State and local sales tax deduction

For individuals living in a state with no personal income tax, Congress has on occasion allowed these folks a deduction for state and local sales tax paid. This deduction currently is on the list of extenders that are needed in 2012. Just like other state and local taxes – property taxes and income taxes, for example – a deduction for state sales tax is allowed for Regular Tax purposes but not for Alternative Minimum Tax payers. Thus, for individuals in these states the extension – or not – of this as an allowable deduction can have a direct impact on their AMT paid.

Small business stock

Gains from the sale of qualifying “small business stock” may not need to be fully reported for purposes of the Regular Tax. For the AMT, however, a portion of the gain needs to be added back into taxable income. Some of the special rules that apply to small business stock are on one-year extenders, so an AMT payer with this item will be affected by these extenders.

Percentage depletion

For investors and operators in the oil and gas business, the use of percentage depletion can trigger the AMT. Percentage depletion computations are complex, with several limitations imposed in the various steps of the calculations. The extension of one of these items, knows as the 100%-of-net-income limitation, could have a direct impact on affected AMT payers.

Conclusion

Politics being politics, one never knows with any certainty what Congress is going to do or when they are going to do it. Historically, however, these extenders – including The Patch – have been enacted, although more often than not well past the deadline but on a retroactive basis. Readers are advised to keep an eye on developments on this important topic.

Posted in AMT credits, AMT Exemption, AMT Items, Credits Allowable, Legislation/tax law changes, State Income & Other Taxes, The "patch" | No Comments »

IRS Releases 2011 Version of Form 6251 – Alternative Minimum Tax-Individuals, a Reminder That It’s Time to Start Thinking about Year-End Tax Planning

Saturday, September 24th, 2011 | Print This Post | Email This Post

The IRS recently released its 2011 version of the Form 6251 – Alternative Minimum Tax – Individuals. With year-end only a few months away, this serves as a timely reminder that anyone stuck in the AMT needs to start thinking about the ways they can reduce this burden. The most effective AMT planning strategies must be implemented by December 31 in order to have any impact on the current year’s taxes. This article provides a general overview of some of the more important of these planning strategies.

AMT exemption amount

Late last year Congress once again adjusted the AMT exemption amount for inflation - for 2011 it is $74,450 for married couples filing a joint income tax return and $48,450 for singles. While Congress hasn’t even started thinking about the “patch” that will be needed again on January 1, 2012, we can guess that at some point that will be taken care of.

Phaseout of the exemption

For taxpayers whose incomes reach a certain level, the exemption is gradually phased out. This phaseout is at the rate of $1 of exemption lost for every $4 of income above the threshold. For 2011 the threshold for marrieds filing jointly is $150,000, and for singles it is $112,500. If a couple’s income is $160,000, for example, the exemption is reduced by $2,500. If the couple’s taxable income reaches $447,800, the exemption is zero.

Capital gains and dividends

While capital losses may be more typical these days due to the stock market’s wild gyrations, it’s important to note the AMT impact that results from capital gains as well as dividend income. These sources of income are taxed at the same 15% rate for both the AMT as well as the Regular Tax, but there is a direct impact on an individual’s AMT burden because of the exemption phaseout discussed above. For example, a $10,000 capital gain by itself can result in $700 of AMT being paid (loss of $2,500 of exemption times the marginal AMT rate of 28%).

Itemized deductions – state and local income taxes

The one item that affects the greatest majority of folks stuck in the Alternative Minimum Tax is the itemized deduction for state and local income taxes. While allowable for the Regular Tax, this deduction is disallowed in its entirely for the AMT. For taxpayers who expect to be in the AMT for 2011, serious consideration should be given to postponing payment of some portion of these taxes into 2012. If the taxpayer is not in the AMT in 2012, real tax dollars can be saved that otherwise would have been “wasted” by not ding this basic planning.

Itemized deductions – property taxes

The next biggest item in terms of AMT exposure is property taxes which, similar to state and local income taxes, are not deductible in computing the Alternative Minimum Tax. Many taxpayers receive their property tax bills in the fall, with a period of months before the taxes are actually due. Just as with the state income tax planning mentioned above, taxpayers currently in the AMT might be better off pushing the payment of these property taxes into 2012.

Other AMT items

There are quite a few other AMT items in addition to those mentioned above. Some of these items are deductions from income that are allowed for Regular Tax purposes but not allowed for the AMT, while others are certain types of income that are treated differently for the Alternative Minimum Tax. The Form 6251, available on the IRS’ web site, serves as a list of all of these items. Taking a look at last year’s tax return serves as a great starting point to see which items are likely to affect the taxpayer again this year.

The value of planning

The average amount of AMT paid by each taxpayer caught in its tentacles is over $5,000. Just a little bit of time spent on basic tax planning can result in some significant amounts being saved!

Posted in AMT Exemption, AMT Items, AMT Planning in General, Capital gains & Dividends, State Income & Other Taxes, Uncategorized | No Comments »

I Am Retired – Does the AMT Apply to Me?

Thursday, March 17th, 2011 | Print This Post | Email This Post

Of all the different types of AMT taxpayers, retirees typically are the most surprised when they find themselves stuck in the Alternative Minimum Tax. Unfortunately, there is no “age exemption” for the AMT – an individual could reach 100 and still be paying it, depending on that person’s level and types of income and tax deductions. In certain cases, the AMT may even hit a retiree harder than a person still working. With a little understanding of the issues and some advance planning, retirees may actually be in a better position than others to do something about the AMT.

There’s a great story that Eric Solomon, Assistant Secretary of the U.S. Treasury for Tax Policy during the Bush administration, used to tell. His father had received a letter from the IRS stating that his 2004 tax return could not be processed because he had not computed his Alternative Minimum Tax. “My dad said, ‘I’m 82. I don’t pay the AMT,’” Solomon would recall. Unfortunately, no such octogenarian exemption exists, but Solomon said he had to spend three hours on the phone with his dad working through the Form 6251.

This article will address both income issues associated with retirees and the AMT as well as deduction issues.

Income issues

Retirement plan distributions

Individuals have many choices as to how they can take distributions from their retirement plans, whether these plans are in the form of pensions or 401(k)-type plans. A lump-sum distribution, or some other accelerated form of distribution, more likely would trigger the AMT than choosing a lifetime annuity. This is because the higher one’s income is in any one year the more likely the AMT exemption is phased out, in turn meaning the more likely the individual is to be in the Alternative Minimum Tax.

Stock options- nonqualified

Many mid- to upper-level employees who work for a corporation, typically a publicly-traded corporation, receive “nonqualified” stock options as part of their compensation packages. Many of these option plans allow the individual a certain period of time after retirement to exercise these options. Similar to the point made above with respect to retirement plans, a retiree must consider the AMT impact when deciding when to exercise these options and how much income will be generated.

Stock options – Incentive Stock Options

If an individual has Incentive Stock Options, the exercise of these in one year can almost guarantee paying the Alternative Minimum Tax. This is because the difference between the value of the stock on the date of exercise and the option price is a direct AMT preference item – unlike the indirect effect the exercise of nonqualified stock options can have as discussed above.

Capital gains

Retirees on occasion may have capital gains that are disproportionately large in comparison to the rest of their income. These gains may result from distributions from mutual funds, over which the individual has no direct control, or from an effort to diversify an investment that is too concentrated in one stock, or from any number of reasons. These sudden bumps in income can cause the retiree to lose a portion of his AMT exemption, resulting in a problem similar to those discussed above.

Deduction issues

Standard deduction

A taxpayer may elect to take the “standard deduction” in lieu of itemizing deductions. The amount of the deduction varies by filing status, but for a couple filing jointly it is $11,600 for 2011. Since no standard deduction is allowed for the AMT, Alternative Minimum Taxable income – the amount on which the AMT is calculated – will be $11,600 higher than Regular Tax taxable income. Add to this the extra $2,300 exemption for folks age 65 and over and one can see why more and more retirees are being pulled into the AMT. Note that an extra amount also is allowed in cases of blindness, further exacerbating the problem for these individuals.

Property taxes and state income taxes – changes in state of residence

An individual who itemizes deductions generally will get a Regular Tax benefit for property taxes and state income taxes, as well as certain other state and local taxes. None of these taxes is allowable as a deduction in computing the Alternative Minimum Tax. Accordingly, like the standard deduction issue discussed above, taxable income on which the AMT is calculated will be higher than Regular Tax taxable income. If a change in state of residence at retirement is contemplated, it is important to plan for the AMT effects. Moving from a high state and local tax jurisdiction to a state without income tax like Florida, for example, could mean falling out of the AMT along with a corresponding opportunity to move income, or deductions, from one year to the other to minimize the AMT.

Summary

A sudden change in one’s income position, as typically happens in the case of retirement, can present significant Alternative Minimum Tax planning opportunities. Deductions that would be lost in an AMT year may be shifted to a Regular Tax year, and income might be taxed at a lower rate in one year versus the other. These principles apply to all future retirement years; not just the year of transition from employment to retirement. While often overlooked, taxes, especially the Alternative Minimum Tax, are a very important part of planning for retirement.

Posted in AMT Exemption, AMT Planning in General, Calculation of the AMT, Capital gains & Dividends, Incentive Stock Options Exercised, Retiree, Standard Deduction, State Income & Other Taxes, Type of Taxpayer | 1 Comment »

Joint Committee on Taxation – Tax Expenditures and the Alternative Minimum Tax

Saturday, March 12th, 2011 | Print This Post | Email This Post

The Joint Committee on Taxation recently issued a report on tax expenditures. “Tax expenditures” are government spending that is accomplished through the Internal Revenue Code – in effect a negative tax. The tax expenditure term was created over 40 years ago by Stanley Surrey, then Assistant Secretary of the Treasury, as a way to describe the political use of tax breaks for means that were more typically accomplished through direct government spending.

Set forth below is an excerpt from this recent report – the part addressing the Alternative Minimum Tax. It makes for interesting reading, especially when one finds such comments as “the AMT is not viewed as part of normal income tax law.”

The report:

Under the Joint Committee staff view of normal tax law, compensatory stock options would be subject to regular income tax at the time the options are exercised and employers would receive a corresponding tax deduction. If the option has a readily ascertainable fair market value, normal law would tax the option at the time it is granted and the employer would be entitled to a deduction at that time. The employee’s income would be equal to the difference between the purchase price of the stock and the market price on the day the option is exercised.

Present law provides for special tax treatment for incentive stock options and options acquired under employee stock purchase plans. When certain requirements are satisfied, then: (1) the income that is received at the time the option is exercised is excluded for purposes of the regular income tax but, in the case of an incentive stock option, included for purposes of the alternative minimum tax (“AMT”); (2) the gain from any subsequent sale of the stock is taxed as a capital gain; and (3) the employer does not receive a tax deduction with respect to the option. The special tax treatment provided to the employee is viewed as a tax expenditure by the Joint Committee staff. However, it should be noted that the revenue loss from the special tax treatment provided to the employee is accompanied by a significant revenue gain from the denial of the deduction to the employer. The negative tax expenditure created by the denial of the deduction for employers is incorporated in the calculation of the tax expenditure.

The individual AMT and the passive activity loss rules are not viewed by the Joint Committee staff as a part of normal income tax law. Instead, they are viewed as provisions that reduce the magnitude of the tax expenditures to which they apply. For example, the AMT reduces the value of the deduction for State and local income taxes (for those taxpayers subject to the AMT) by not allowing the deductions to be claimed in the calculation of AMT liability. Similarly, the passive loss rules defer otherwise allowable deductions and credits from passive activities until a time when the taxpayer has passive income or disposes of the assets associated with the passive activity. Exceptions to the individual AMT and the passive loss rules are not classified as tax expenditures by the Joint Committee staff because the effects of the exceptions already are incorporated in the estimates of related tax expenditures. In one case the restrictive effects of the AMT are presented separately because there are no underlying positive taxexpenditures reflecting these effects: the negative tax expenditures for the AMT’s disallowance of personal exemptions and the standard deduction.

Posted in Incentive Stock Options Exercised, Legislation/tax law changes, Personal Exemptions, Standard Deduction, State Income & Other Taxes | No Comments »

Roth IRA Conversions and the Alternative Minimum Tax

Saturday, January 22nd, 2011 | Print This Post | Email This Post

Everyone with a traditional IRA should be looking into whether converting to a Roth IRA might make sense for them, because the ability to shelter future earnings from taxation is a very attractive feature of the Roth. The difficult part in doing a conversion analysis, however, is in forecasting the tax bracket that will apply when the IRA monies are distributed in the future. For alternative minimum tax payers, the Roth analysis can be especially difficult.

Roth IRA vs. traditional IRA

Contributions to a traditional IRA are tax-deductible when made, subject to income restrictions and other limitations. In return, distributions taken from the IRA, typically in retirement, are taxable, along with the earnings on the IRA while it was invested. For a Roth IRA, on the other hand, there is no tax deduction when the contributions are made, and in return there is no taxable income at the time of taking distributions. The feature particularly attractive to a Roth is that the earnings also are not taxable.

Roth conversions

Prior to 2010 there were income limits on who was allowed to convert a traditional IRA to a Roth IRA. These income limits prevented most folks who had the wherewithal to make such a conversion from being able to do so. The removal of these income limits has resulted in a lot of articles being written on this issue, and many investment advisers continue to meet with their clients to try to figure out whether or not a conversion sense for them.

The basics of a Roth conversion are simple. In exchange for paying taxes now, an individual will pay no taxes when the monies are withdrawn from the IRA. Sounds simple, yes, but the analysis actually is pretty difficult because of the variables involved, particularly the individual’s tax rates, both now and in the future.

Example

Assume an individual has a traditional IRA with a balance of $100,000, and has been able to deduct all of the contributions that have been made to it. If that individual is in the 35 percent tax bracket, electing to convert it to a Roth today will mean tax due of $35,000. The remaining balance of $65,000 will continue to be invested, and at retirement there will be no taxes due on the $65,000 or on any of the investment earnings. If one assumes investment growth of 50 percent between now and retirement, the individual will end up with a tax-free distribution of $97,500.

Compare this to leaving the IRA alone and not making the conversion. Fifty percent growth will mean the IRA will be worth $150,000 at retirement, before tax. If the individual is still in the 35 percent bracket, the tax will be $52,500, leaving a net amount for the individual of $97,500. How interesting, one notes – the result is exactly the same!

Tax planning for a Roth conversion

So now you know the “secret” behind the Roth conversion analysis – investment yield is irrelevant. The entire analysis is in the tax rates – what tax bracket you are in today vs. what tax bracket you expect to be in at retirement. With Republicans fighting Democrats over who is and who is not “rich,” and continuous last-minute temporary “extenders” of our individual income tax rates it is, in fact, almost impossible to do with any degree of accuracy. But that doesn’t mean the analysis shouldn’t be done. Set forth below is all the information you need.

What tax bracket are you in in 2011?

Using the married-filing-jointly status as an example, here are the 2011 tax tables, if you are paying the Regular Tax:

Up to $17,000 10%

Excess up to $69,000 15%

Excess up to $139,350 25%

Excess up to $212,300 28%

Excess up to $379,150 33%

Over $379,150 35%

Here are the tax tables, if you are stuck in the Alternative Minimum Tax:

Up to $175,000 26%

Over $175,000 28%

What tax bracket will you be in after you retire, at the time of taking the IRA distributions?

This, of course, is the really hard part, especially in view of the ongoing push from some of our leaders in Washington (i.e., the Democrats) to raise our tax rates. There are three choices in how to approach this:

One is to assume you will be in the Regular Tax, and that the Republicans will somehow keep our tax brackets the same as they are today. In this case, use the Regular Tax table shown above.

Another is to assume you will still be stuck in the AMT, and that those brackets will remain what they are today. Here one would use the AMT tax table above.

The third is to forecast what the tax brackets will be if the Democrats succeed in raising our taxes. While it is of course impossible to predict what might ultimately come out of Washington, as a starter here are projected brackets prepared by the Tax Foundation, a Washington-based tax “think tank,” under what it calls a “full expiration” scenario:

Up to $57,650 15%

Excess up to $139,350 28%

Excess up to $212,300 31%

Excess up to $379,150 36%

Over $379,150 39.6%

For reference, other scenarios also are presented on the Tax Foundation’s web site.

State income taxes

In addition to the core tax bracket analysis using Federal tax rates, consideration also must be given to state income taxes. A state income tax rate of 6 percent would mean another $6,000 in taxes in the above example. The two things to consider here are: 1) the effect of state income taxes on one’s Alternative Minimum Tax (high state taxes are the most common problem for AMT payers), and; 2) the possibility that retirement could involve relocating to a state with no income tax (Florida, for example). Either or both of these would have a significant impact on a conversion analysis.

Summary

Roth conversions can make sense in situations where the taxes paid today are less than what they otherwise would be at retirement. As with all tax planning, no generalizations can be made. Everyone’s situation is different, so one has to take a big gulp and make a best guess on the future tax bracket that will apply. Also, an online calculator is a must, especially when doing AMT planning. For an excellent one that is not only easy to use but also free see http://www.amtindividual.com/alternative-minimum-tax-calculator-assistant101.html.

Posted in AMT Planning in General, Calculation of the AMT, Legislation/tax law changes, State Income & Other Taxes | 1 Comment »

Last-Minute AMT Calculations and Planning

Thursday, December 30th, 2010 | Print This Post | Email This Post

The last-minute tax relief bill signed just a few weeks ago may have saved many from being pulled into the Alternative Minimum Tax for the first time, but what about the four million individual taxpayers already stuck there? Not even a “thank-you” from Congress or the President for the billions of dollars paid each year in AMT by these folks, much less any relief being planned – our country’s spending habits are just too great. But, while there is no way to make it just go away, there certainly is something these individuals can do about the AMT. With the help of a computerized AMT calculator, the amount of AMT paid can be reduced.

Let’s look at some facts. Last week the IRS released its Statistics of Income Report for tax returns filed in 2009, with some staggering information on the AMT. Here is what it shows:

- The average amount of AMT paid was $6,500.

- For the sixth straight year, the total amount of AMT paid showed a substantial increase – more than six percent higher than the prior year.

- There are taxpayers at every income level – from $0 of income to over $10 million – paying the AMT.

- Once income reaches $100,000, the chances of being pulled into the AMT become much greater.

- The income range of $200,000 to $500,000 is the unfortunate AMT “sweet spot,” with an amazing 70% of all taxpayers in this group paying the AMT.

So what can you do about your $6,500? Particularly for those in the “sweet spot” income range, chances are most of your AMT is being triggered by the one single item found on nearly 95% of all AMT payers’ tax returns – state and local taxes. The biggest culprits in this area are state taxes on income and property taxes on one’s home, with city and other municipal taxes, if those apply, compounding the problem. The AMT rule that comes into play here is the one that allows a full deduction for these taxes when computing the Regular Tax liability, yet denies any deduction for these when computing the AMT.

For example, suppose a family of four has taxable income for the Regular Tax – the starting point in all AMT computations – of $200,000. State income taxes and real estate taxes easily could amount to $20,000 worth of itemized deductions. What this means is that taxable income for this family for the Alternative Minimum Tax would be $234,600 – nearly 20% higher. This is because personal exemptions, worth $14,600 to this family in 2010, also are denied as a deduction for the AMT. Note that this simple example doesn’t even consider the 20-plus other AMT items that could affect this taxpayer (see IRS Form 6251). With this big a difference in taxable income, one can almost guarantee that this taxpayer will be stuck in the AMT.

So, again, what can be done? With an AMT calculator, it’s actually pretty easy. Suppose a property tax bill could be paid this year or in January of next year. If you move a $5,000 AMT item from one year to the next, it could mean lowering your AMT by nearly $1,500. If you could move $5,000 of state income taxes from one year to the next, now you have potentially $3,000 of AMT savings. It’s that easy!

But to do these calculations by hand is way too cumbersome, and of course prone to mistakes. That’s where a computerized calculator, like the one available – for free – at http://www.amtindividual.com/alternative-minimum-tax-calculator-assistant101.html, is essential. This web site also will hand-walk you through all of the AMT items, allowing you to make the most accurate calculations possible.

Give it a try. Wouldn’t you rather put an easy $1,000 or more in your pocket rather than simply continuing to just turn it over to the Government?

Posted in AMT Items, AMT Planning in General, Calculation of the AMT, Legislation/tax law changes, State Income & Other Taxes | No Comments »

Real Estate and the AMT: Property Used in the Taxpayer’s Trade or Business

Sunday, October 10th, 2010 | Print This Post | Email This Post

The Alternative Minimum Tax is a very important consideration when real estate is involved because just about every tax rule applying to real estate is different for the AMT than it is for the Regular Tax. This last part of our four-part series will talk about real estate used in a taxpayer’s trade or business. This is a big investment for most small businesses, and the differences in tax treatment between the Regular Tax and the AMT can be significant.

For this article we are talking about businesses held in the form of a sole proprietorship, an S corporation, an LLC or a partnership. All of the Regular Tax and AMT issues discussed here show up on the individual owner(s) Form 1040 because every one of these types of businesses is treated as a “pass-through” entity for tax purposes.

Following the order of the issues described in the earlier parts of this series, here is a look at them as they apply to trade or business property.

Interest expense

Interest paid on a mortgage taken out to acquire business property is fully deductible, both for the Regular Tax and the Alternative Minimum Tax. Similar to the last article on rental/investment property, the limitations discussed in the first article on home mortgage interest simply not apply.

If the equity in the business property is used as security for an additional loan – a second mortgage, for example – then the taxpayer must look to the use of the proceeds of that loan. If the proceeds are used for a car loan or to finance a child’s education or for any other purpose, then the interest is nondeductible personal interest. So long as the proceeds are used in the business, the interest is fully deductible.

Property taxes

Property taxes paid on trade or business property are allowed in full both for Regular Tax purposes as well as for the Alternative Minimum Tax.

Depreciation

Depreciation is allowed for property used in a trade or business. The portion of the cost allocable to land is not depreciable, but for the building itself and the furniture & equipment a depreciation deduction may be taken.

Real property (the legal definition of the building) used in a trade or business may only be depreciated for Regular Tax purposes under the “straight line” method over a useful life of 39 years. Thus, a property with $390,000 allocated to the building would be depreciated at the rate of $10,000 per year.

Personal property (this is the legal definition of things such as machinery and equipment, furniture and fixtures, and computer equipment) may be depreciated for Regular Tax purposes under an “accelerated” method over a useful life of five or seven years. An accelerated method allows a larger depreciation deduction in the early years, in recognition of the obsolescence factor in new property (computers are a good example).

For purposes of the AMT, however, personal property may only be depreciated by using a straight-line method. Thus, an AMT item will be generated in the early years if the accelerated method is used.

Planning idea – consider electing to use the straight-line method of depreciation for Regular Tax purposes. While giving up a little tax benefit from the greater depreciation in the early years, it could mean avoiding paying the AMT.

Active/passive investment rules and the “at-risk” rules

The active/passive investment rules generally do not apply to a small business, because the business owner almost always is heavily involved in the day-to-day operations of the enterprise, and, thus, by definition is active. These rules would apply, however, to a financing partner or a silent partner who is not so involved. As a reminder, these rules as well as the at-risk rules would apply only in the years the business had losses.

Sale of the property

Several different AMT issues can arise on the sale of business property. These are essentially the same issues as those discussed in the last article, on Rental/Investment Property, with perhaps a few minor differences.

One AMT issue is that the taxpayer’s gain or loss will be different for the AMT than it is for Regular Tax purposes if the business personal property was depreciated using an accelerated method for Regular Tax purposes. Because the straight-line method had to be used for Alternative Minimum Tax purposes, the gain or loss will be different and the taxpayer will have an AMT item to report on the Form 6251.

Gains on the sale of business property generally are capital gains, although a portion will be treated as ordinary income if the accelerated depreciation method was used. Capital gains in and of themselves are not an AMT item, but they definitely can result in AMT being paid. This is because the AMT exemption – that keeps many taxpayers out of the Alternative Minimum Tax – is phased out for taxpayers above certain income levels. Additional income, even capital gains, can have the result of reducing the exemption which in turn increases taxable income for AMT purposes.

This issue is discussed in an article posted on amtblog.com on December 13, 2009. This article also can be found by searching for “alternative minimum tax planning – investments – capital gains.”

This is the final of four articles on Real Estate and the AMT. A new series of articles will begin soon, focusing on different types of taxpayers and the things to watch out for, along with associated planning opportunities, for each of these types. Stay tuned!

Posted in AMT Planning in General, Capital gains & Dividends, Depreciation & Disposition of Property, Investment Interest Expense, State Income & Other Taxes | No Comments »