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Watch Out for Five AMT Traps for Investors

The dangers of the alternative minimum tax (AMT) are now well-publicized, but they can still surprise investors who normally don't face this problem. If you are not careful, you might fall victim to this “stealth tax.”

Background: The AMT runs on a separate track alongside your regular income tax calculation. The starting point is your annual taxable income. Next, you add in special “tax preference items” and make other technical adjustments. Then you subtract a special exemption amount based on your tax return filing status. Note: Congress just approved slightly higher exemption amounts for 2006 as part of new tax legislation.

Finally, you apply the AMT rate to the remainder and compare it with your regular tax liability. You effectively pay the higher of the two. The AMT rate is 26% for the first $175,000 of AMT income; 28% above that mark.

You may not be paying close attention to the AMT if you haven't paid it in the past. But now your investment activities could push you into the danger zone. Consider the following pitfalls.

1. Capital gains and dividends: Thanks to a recent tax law change, long-term capital gains and qualified dividends are taxed at just a 15% rate. But these low-taxed gains and dividends still count toward the exemption levels. Therefore, some profitable sales can push you over the exemption amount for your filing status.

Even worse, your AMT exemption is reduced when AMT income exceeds $150,000 for joint filers; $112,500 for single filers. The reduction is equal to 25% of the excess.

2. Home equity interest: Usually, you can deduct mortgage interest paid on the first $100,000 of home equity debt, regardless of the use of the proceeds. But home equity interest can be deducted for AMT purposes only if the funds are used to buy or improve a qualified residence.

If you use the proceeds for investment purposes—say, to invest in stock or real estate—you can write off the interest under the AMT as investment interest. Be careful to document use of the funds.

3. Investment expenses: You can generally write off investment-related expenses—such as investment advisory fees, real estate transfer taxes and the like—as miscellaneous itemized deductions on your personal return. You can deduct these expenses to the extent your annual total exceeds 2% of your adjusted gross income.

Caution: There is no such write-off of miscellaneous expenses for the AMT. Keep this rule in mind if you are used to writing big checks for investment expenses.

4. Incentive stock options: With an incentive stock option (ISO), you can buy shares of stock at a discount. Generally, the discount is tax-free when you exercise the option. No tax is owed until the shares are sold. However, the discount is taxable for AMT purposes when it is exercised—even though you don't receive any cash. This can be particularly troublesome if the price of the stock falls after you have exercised your option. As a result, you might wait until next year to exercise ISOs.

5. Private activity bonds: The interest from certain municipal bonds used to fund private activities like sports stadiums is added to your AMT income. Because private activity bonds often offer a better rate of return than other municipal bonds, you may be tempted to hold them longer. Thus, they can trigger an unexpected AMT bill. One possible way to avoid problems is to invest in municipal bonds that are advertised as being “100% AMT-free.”

Conclusion: Make projections now about your potential AMT liability for 2006. Depending on the results, you might need to take action before year-end.

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	[ return to list ] Watch Out for Five AMT Traps for Investors The dangers of the alternative minimum tax (AMT) are now well-publicized, but they can still surprise investors who normally don't face this problem. If you are not careful, you might fall victim to this “stealth tax.” Background: The AMT runs on a separate track alongside your regular income tax calculation. The starting point is your annual taxable income. Next, you add in special “tax preference items” and make other technical adjustments. Then you subtract a special exemption amount based on your tax return filing status. Note: Congress just approved slightly higher exemption amounts for 2006 as part of new tax legislation. Finally, you apply the AMT rate to the remainder and compare it with your regular tax liability. You effectively pay the higher of the two. The AMT rate is 26% for the first $175,000 of AMT income; 28% above that mark. You may not be paying close attention to the AMT if you haven't paid it in the past. But now your investment activities could push you into the danger zone. Consider the following pitfalls. 1. Capital gains and dividends: Thanks to a recent tax law change, long-term capital gains and qualified dividends are taxed at just a 15% rate. But these low-taxed gains and dividends still count toward the exemption levels. Therefore, some profitable sales can push you over the exemption amount for your filing status. Even worse, your AMT exemption is reduced when AMT income exceeds $150,000 for joint filers; $112,500 for single filers. The reduction is equal to 25% of the excess. 2. Home equity interest: Usually, you can deduct mortgage interest paid on the first $100,000 of home equity debt, regardless of the use of the proceeds. But home equity interest can be deducted for AMT purposes only if the funds are used to buy or improve a qualified residence. If you use the proceeds for investment purposes—say, to invest in stock or real estate—you can write off the interest under the AMT as investment interest. Be careful to document use of the funds. 3. Investment expenses: You can generally write off investment-related expenses—such as investment advisory fees, real estate transfer taxes and the like—as miscellaneous itemized deductions on your personal return. You can deduct these expenses to the extent your annual total exceeds 2% of your adjusted gross income. Caution: There is no such write-off of miscellaneous expenses for the AMT. Keep this rule in mind if you are used to writing big checks for investment expenses. 4. Incentive stock options: With an incentive stock option (ISO), you can buy shares of stock at a discount. Generally, the discount is tax-free when you exercise the option. No tax is owed until the shares are sold. However, the discount is taxable for AMT purposes when it is exercised—even though you don't receive any cash. This can be particularly troublesome if the price of the stock falls after you have exercised your option. As a result, you might wait until next year to exercise ISOs. 5. Private activity bonds: The interest from certain municipal bonds used to fund private activities like sports stadiums is added to your AMT income. Because private activity bonds often offer a better rate of return than other municipal bonds, you may be tempted to hold them longer. Thus, they can trigger an unexpected AMT bill. One possible way to avoid problems is to invest in municipal bonds that are advertised as being “100% AMT-free.” Conclusion: Make projections now about your potential AMT liability for 2006. Depending on the results, you might need to take action before year-end. [ return to list ]
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