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Sidestep 5 Alternative Minimum Tax traps for investors

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in Small Business Tax

The alternative minimum tax (AMT) doesn’t appear to be going away anytime soon. According to one estimate, the number of individuals paying the AMT in 2010 could jump to more than 30 million. 

Strategy: Determine if you could be hit by this “stealth tax” for the first time this year. In particular, investors may be blindsided.

How it works: The starting point for the AMT is your annual taxable income. Next, special “tax preference items” are added and other technical adjustments are made. Then you subtract a special exemption amount based on your tax filing status.

Finally, the AMT rate is applied to the remainder and compared to 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.

Increased investment activity could push you into the danger zone. Here are five prime examples: 

1. Capital gains and dividends: For 2010, long-term capital gains and qualified dividends continue to be taxed at a 15% rate. But low-taxed gains and dividends still count as income for purposes of the AMT exemption phaseout rule. The AMT exemption starts to phase out when AMT income exceeds $150,000 for joint filers; $112,500 for single filers. The reduction is equal to 25% of the excess. For example, if someone expects to exceed the threshold for 2010 and he or she pulls down a $5,000 long-term capital gain, the exemption is cut by $1,250 (25% of $5,000).

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.

Strategy: If the proceeds are used for investment purposes—say, to invest in stock—you can write off the interest under the AMT as investment interest. Document use of the funds.  

3. Investment expenses: Generally, investment-related expenses—such as investment advisory fees, real estate transfer taxes and the like—are claimed as miscellaneous itemized deductions. The total is subject to a 2%-of-AGI limit.

Caution: There’s no such write-off of miscellaneous expenses for the AMT. Don’t forget this key tax difference.

4. Incentive stock options:
With an incentive stock option (ISO), an employee buys shares of stock at a discount. For regular income tax purposes, the discount is tax-free when you exercise the option. But the discount is taxable for AMT purposes when it is exercised, even though the employee doesn’t receive any cash. This can be particularly troublesome if the price of the stock falls after you have exercised the option.

Strategy: Wait until next year to exercise ISOs to avoid AMT headaches this year.

5. Pass-through entities: If you’re a “silent partner” or a passive investor in an S corp or limited liability company (LLC), items of income and loss are passed through to your personal return. Thus, you might be exposed to the AMT and not even know it until tax return time.

Tip: The interest from “private activity” municipal bonds is normally added to AMT income. But this rule is repealed for private activity bonds issued in 2009 and 2010.

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