[Editor's Note: If you’re looking to add diversity to your portfolio with a real estate fund that’s already made big waves in a short period of time, WCI wants to introduce you to the Peak Housing REIT. Though the fund is relatively new, it already has a fantastic track record and is comfortably exceeding its 15% projected return. What’s unique about this REIT is that it invests almost exclusively in single-family homes (instead of multi-family assets), so it would also add diversity into your real estate portfolio. For more info, make sure to visit The Peak Group today!]

 

By Dr. James M. Dahle, WCI Founder

In 1969, Treasury Secretary Joseph Barr announced that 155 high-income households hadn't paid any taxes at all that year. The obvious public outcry prompted Congress to institute an add-on tax it called the alternative minimum tax (AMT), taking effect the next year. As part of the 1982 tax reforms under President Reagan, it was changed from an add-on tax to an alternative tax system, but the goal of ensuring that high-income individuals and corporations had to pay some taxes remained.

Note that there is no “minimum income tax” at the other end of the income spectrum, which is why there is a large percentage of households that have a $0 federal income tax bill every year (up from the high 40% range to 61% in 2020 due to the pandemic stimulus). While those folks do pay payroll taxes, sales tax, property taxes, and more, anything withheld from paychecks during the year for federal income tax is returned to them as a tax refund. At any rate, the point of the AMT is to ensure that high earners pay a certain amount of money in federal income tax—not that everyone pays something in federal income tax.

Unfortunately, there was a huge flaw in the AMT system as implemented—the exemption amount was never indexed to inflation. As a result, the tax affected more and more Americans each year with some estimating that more than 15% of people who made $75,000-$100,000 had to pay AMT. In 2017, five million Americans paid tax under the alternative minimum tax system instead of the regular federal income tax system. This includes lots of white coat investors. In 2018, the Tax Cuts and Jobs Act (TCJA) largely rectified this issue and in 2018, only 150,000 taxpayers paid under the AMT system. Unfortunately, due to the fact that it was passed through the Senate via the budget reconciliation process, many of the provisions in the TCJA are temporary, and unless Congress makes some changes, we will revert back to the pre-2018 AMT system in 2026.

 

What Is the Alternative Minimum Tax (AMT)?

The alternative minimum tax was instituted back in 1969 when those 155 American families who earned more than $1 million owed $0 in federal income tax. This was due to the way deductions were established at the time. Congress didn’t think these families were paying their fair share, and instead of changing the tax code for everyone, it decided to institute an entirely new tax structure to bring these families back into the tax-paying fold.

In its most basic form, the AMT is a totally separate way of calculating how much you owe in taxes. The IRS explains on its website:

“The AMT is the excess of the tentative minimum tax over the regular tax. Thus, the AMT is owed only if the tentative minimum tax for the year is greater than the regular tax for that year. The tentative minimum tax is figured separately from the regular tax. In general, compute the tentative minimum tax by:

  1. Computing taxable income eliminating or reducing certain exclusions and deductions, and taking into account differences with respect to when certain items are used to compute regular taxable income and alternative minimum taxable income (AMTI),
  2. Subtracting the AMT exemption amount,
  3. Multiplying the amount computed in (2) by the appropriate AMT tax rates, and
  4. Subtracting the AMT foreign tax credit.”

To simplify, think of AMT as a flat tax rate of approximately 28%. This is different than the effective and marginal tax rates. Under AMT, there are only two marginal brackets—a 26% bracket and a 28% bracket. For the tax year 2021, the 28% bracket kicks in after $199,900 of income.

 

When Do You Have to Pay AMT Tax? 

The Alternative Tax System (AMT) is a complete tax system, run in parallel to the regular one with which you're probably more familiar. Each year, you technically have to compute your taxes under both systems and then pay whichever is higher. Prior to 2018, it generally hit those with an income between $115,000-$415,000 the hardest, which is a large percentage of docs.

The AMT is actually quite a bit simpler than the regular tax code. There is only one exemption amount—$118,100 married ($75,900 single) for 2022—and only two brackets—26% up to $206,100 for singles and MFJ ($103,050 MFS) and then 28% above that. There are no personal exemptions or standard deductions. Some of the common deductions used in the regular tax system are disallowed under the AMT.

Prior to 2018, the AMT exemption started phasing out at an income of just $120,700 ($160,900 MFJ). However, as part of the TCJA, that exemption phaseout was dramatically increased, and for tax year 2022, it starts phasing out at $539,900 ($1,079,800 MFJ). It phases out relatively slow, you lose 25 cents of exemption for every dollar of additional taxable income. The exemption is completely gone by $843,500 ($1,552,200 MFJ).

The other major change to the AMT with the TCJA was that many of the deductions that were allowed under the regular system but not the AMT were scaled back or eliminated altogether (personal exemptions, state and local tax deductions, and miscellaneous deductions on Schedule A). The net effect was that for a much larger number of people, the calculation under the regular tax system resulted in a higher amount of tax due than the calculation under the AMT. Thus, a lot fewer people paid “AMT tax,” the difference between the amounts due under the two systems.

 

Who Pays Alternative Minimum Tax? 

Prior to 2018 and again starting in 2026 if Congress makes no changes, three groups of people made out poorly under the AMT. The more of these groups you belong to, the more likely you are to have to pay additional tax because of it.

  1. People who pay high state and local income taxes. Unlike many deductions which are the same (or even better due to the higher marginal rates), state and local income taxes aren't deductible under the AMT. Thus, those who pay them are more likely to have to pay under the AMT system.
  2. People with lots of kids. “Finally!” say those DINKs. But since there are no personal exemptions for those with 12 kids, their tax burden under AMT is likely to be higher than under the regular system.
  3. People who live in high cost of living areas. Not only are many high cost of living areas (such as California and New York City) also high state/local tax areas, but they have the unfortunate effect of higher salaries to go with the higher cost of living. The higher salary triggers the AMT.

These deductions/exemptions that were valid under the regular tax system but not under the AMT are called “AMT Preference Items,” and prior to 2018, the most important one was the state and local income tax deduction (62%) followed by the personal exemptions (21%) and the miscellaneous deduction for business expenses (9.5%). With those gone from 2018-2025, the most important preference items are the (now higher) standard deduction, net operating losses, depreciation, and passive losses. So, if you are itemizing due to having a lot of deductible mortgage interest or charitable deductions and if you have no depreciation, passive losses, or business losses, then you are very unlikely to pay under the AMT system. Exercising incentive stock options, realizing a very large capital gain, and investing in “private activity” (conduit) bonds are also good ways to end up paying under AMT.

This chart from the Urban-Brookings Tax Policy Center demonstrates how many people pay or will pay under AMT each year under current law.

 

How Many Pay Alternative Minimum Tax?

 

Do I Have to Pay Alternative Minimum Tax?

How do you know if you'll have to pay alternative minimum tax? The single best way is to use tax software. It'll compute it automatically. If you need to know before you do your taxes in the spring, then you'll need to estimate your taxes. If you're too cheap to fork out for TurboTax, you can just spend a few hours with Form 6251. Don't forget the 12 pages of instructions.

But for high earners, the Tax Cuts and Jobs Act of 2018 provided good news. The law increased the exemption for those who would have to pay AMT, meaning fewer people would get ensnared by the AMT, and it drastically increased the limits for the exemption's phase-out, meaning more people could remain in the safe harbor of the exemption. But remember, the changes to the AMT are only in effect until 2026.

 

How to Avoid AMT

If you owe AMT now, there's not a lot you can do about it other than avoiding private activity bonds and being careful about realizing large capital gains and exercising stocks options. Prior to 2018 and beginning again in 2026 under current law, there are a few things you could (will be able to) do:

If you find you're getting hit with the AMT each year and would prefer not to, you need to increase your deductions that actually count under the AMT. The best options are your retirement accounts. Each dollar stuffed into a 401(k), profit-sharing plan, SEP IRA, or defined benefit plan is a dollar off your taxable ialternative minimum taxncome under both systems. To make things better, you get to keep that dollar, at least until you lose (hopefully a tiny) part of it to taxes upon withdrawal a few decades from now.

The worst option is to disown your kids. This doesn't actually affect the amount you owe under AMT, but starting again in 2026, it will increase the amount owed under the regular tax code, so you can pay that instead of AMT. You can also move out of Manhattan or California. This is smoke and mirrors, though, since it will just increase your federal income tax so you won't pay the AMT instead (although the decrease in state and local taxes—not to mention the cost of living—will probably more than make up for it).

If, for some reason, it's municipal bond interest that's pushing you into the AMT, you might want to consider that when trying to determine your most tax-efficient asset allocation for your portfolio. You can also buy a bigger house (or do a money-out refinance) so you're paying more mortgage interest, or you can give more money to charity. These deductions can actually be more valuable for someone paying AMT than someone who isn't. It can also be helpful to stay out of the $150,000-$415,000 income range. Perhaps you should realize a $1 million capital gain all in one year rather than spread it out. Part-time work may also become more attractive to you. But in the end, there isn't a lot you can do about AMT.

 

What Deductions Are Typically Safe Under the AMT? 

  • Charitable contributions
  • Mortgage interest for your personal residence (note the home equity loan exception below)
  • Deductions for your business taken on Schedule C or through your LLC or S Corp
  • Retirement plan contributions

 

What Deductions or Tax-Advantaged Issues Can Commonly Cause a Physician to Be Subject to the AMT?   

Under current law:

  • Taking the standard deduction
  • Exercising incentive stock options
  • Large capital gains
  • Private activity bonds
  • Depreciation
  • Passive losses
  • Business losses

Starting again in 2026, all of the above plus:

  • Property taxes
  • State and local taxes
  • Mortgage interest for certain home equity loans
  • Unreimbursed business expenses deducted on Schedule A
  • Professional fees deducted on Schedule A (including legal and investment advisory fees)

 

What Are Some Ways to Potentially Reduce Exposure to the AMT?

  • Claim itemized deductions even if smaller than the standard deduction
  • Ask for a larger expense reimbursement account from your employer in exchange for a smaller salary
  • Increase contributions to retirement plans offered by your employer
  • Use a dependent care reimbursement arrangement through your employer to deduct your childcare expenses rather than claiming these deductions on your tax return
  • Consider timing state, local, and property tax payments to bundle them into an every-other-year payment structure (2026 and later)
  • Reduce exposure to private activity municipal bonds
  • Have your investment advisor bill fees to your IRAs or 401(k) rather than your taxable (non-qualified) account (if you fall under AMT, then you can't deduct investment advisory or other professional fees even if they exceed the 2% threshold) (2026 and later)
  • Consider converting traditional IRA funds to Roth IRA funds if you are comfortable with a 28% tax rate.

 

Good News About the AMT

Everyone in both political parties knows this system sucks and is a huge flaw, and prior to 2018, they constantly discussed fixing it. They were hesitant to do so, however, because it brought in a lot of money (~$100 billion a year, or about 4% of total federal income tax revenue). Fixing it would mean either spending less or raising another tax, which would just piss someone else off. However, they got over it when they passed the TCJA, and there is a good chance that the tax changes in the TCJA will be extended beyond 2025, especially if Republicans are back in power after the 2024 presidential elections.

There is another nice thing about the AMT. The extra amount paid if you're caught by the AMT can be applied as a credit to your regular taxes in future years, although I understand this generally doesn't apply to “exclusion items” like state taxes and exemptions for lots of kids, which I suspect is what caused (and will cause) a lot of doctors to pay AMT.

What do you think? Did you pay AMT prior to 2018? Are you paying it now? Do you expect to pay it again starting in 2026? What have you done to avoid it? Comment below!

[This updated post was originally published in 2012.]