How the AMT affects long-term capital gain rates: tax advisers and their clients should be aware of the interaction between the capital gain tax rates and the alternative minimum tax (AMT) when planning for the realization of long-term capital gains (LTCGs). This article examines how the AMT affects the 15% LTCG rate.

Tax advisers frequently are asked to estimate the potential effect of large long-term capital gains (LTCGs) on Federal tax. Such gains can occur from the sale of a home, investment properties or securities. Common wisdom is to apply the maximum 15% Federal capital gain rate to the difference between the estimated sale proceeds and the tax basis. Unfortunately, however, the standard 15% estimate is often inaccurate, due to the broadening application of the alternative minimum tax (AMT). This article (1) discusses the AMT's effect on the capital gain structure, (2) provides examples illustrating the problems in relying on the 15% rate and (3) offers guidance to improve the tax liability estimate for large capital gains.

Background

The Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA) (1) amended Sec. 1(h) and lowered the maximum tax rates applicable to LTCGs. For asset sales after May 6, 2003, a 15% maximum rate replaced the old 20% rate under Sec. 1(h)(1)(C). Rates were also reduced in Sec. 1(h)(1)(B) to 5% for taxpayers in the 10% and 15% income tax brackets. Under sunset provisions, these rates will expire for tax years beginning after 2008, and the old rates will apply again.

The JGTRRA LTCG rates are also used to compute a taxpayer's AMT liability under Sec. 55(b)(3). The AMT exemption was increased to $40,250 for unmarried taxpayers, $58,000 for married filing jointly (MFJ) and $29,000 for married taxpayers filing separately. These increases apply to 2003-2005 tax years and will revert to the 2000 amounts ($33,750, $45,000 and $22,500, respectively) for tax years beginning in 2006. (2) The lower LTCG rates and the greater AMT exemptions are generally favorable to taxpayers. However, they may expose certain taxpayers to AMT, because including LTCGs in alternative minimum taxable income (AMTI) can reduce the exemption. This adverse effect can happen with either the new or old AMT exemptions, although it will vary depending on which exemption applies.

How AMT Affects LTCGs

The following examples illustrate the problem for a tax year beginning in 2005 under different filing statuses and various LTCG amounts. The examples use 2005 personal tax rates, standard deductions and personal exemptions.

Example 1--Single filer: S is 55. She is a single filer with no dependents. She has $75,000 salary and $5,000 interest in 2005, giving her adjusted gross income (AGI) of $80,000. S anticipates selling her principal residence, which is fully paid off. The home was purchased in 1992 for $150,000 and, after capital improvements, has a $200,000 adjusted basis. The net sales price of the home is estimated at $750,000. If S were to sell her home in 2005, what would be the estimated Federal income tax cost?

The traditional calculation for the incremental Federal income tax cost is:

Net sales price            $750,000
Less: adjusted basis        200,000
Less: Sec. 121 exclusion    250,000
Net capital gain           $300,000
Tax at 15%                  $45,000

The incremental tax on the LTCG is the difference between what S would have paid on her regular income without the LTCG, and the total she will have to pay including it. Her Federal tax without the capital gain would be calculated as follows:

AGI                        $80,000
Less: personal exemption     3,200
Less: standard deduction     5,000
Taxable income             $71,800
Tax                        $14,615

Adding the LTCG and calculating AMT (assuming no tax preference items) results in the following:

AMT calculation
Taxable income          $375,000
Addbacks:
  standard deduction       5,000
  personal exemption           0 (phased out)
AMTI                    $380,000
Less: AMT exception            0 (phased out)
Less: Capital gain      $300,000
AMT base                 $80,000

Tentative
  tax (TMT):             $20,000 ($80,000 x 0.26)
Plus: capital gain tax   $45,000
Total TMT                 65,800
Less: regular tax        $60,000
AMT                       $5,293

In Example 1, the sale of the personal residence phased out the AMT exemption and triggered an additional Federal tax liability. It also served to phase out the $3,200 personal exemption and increased taxable income to $375,000 ($71,800 + $300,000 + $3,200). The total added Federal tax liability is $51,185, the difference between the TMT ($65,800) and the regular income tax on the ordinary income without the sale ($14,615). Thus, the increase in tax results in an average 17.1% tax rate ($51,185/ $300,000) on the taxable gain.

For a single taxpayer such as S, the 2005 $40,250 AMT exemption is phased out at the rate of 25% of AMTI in excess of $112,500. The exemption phaseout is complete at income of $273,500 (($40,250 x 4) + $112,500)). After this point, the difference between the regular tax and the AMT will remain constant (assuming no other tax preference items). For example, if S's net taxable capital gain on her home was only $193,500, she would still owe $5,293 additional Federal AMT. Her average tax rate on a sale for that amount would be 18.2% ($35,210/$193,500), because the AMT exemption is still fully phased out at that price, as is the personal exemption. When income exceeds the top of the phaseout range, the marginal rate is 15%, because no additional AMT is accruing.

As was mentioned, for tax years beginning in 2006 and later, the AMT exemption for single fliers is scheduled to return to $33,750. Depending on the personal exemption, standard deduction, phaseout ranges and rate schedules then in place, the additional tax may be reached with smaller LTCGs.

Example 2--HOH: The facts are the same as in Example 1, except that S is a head of household (HOH) with one qualifying dependent and has a $193,500 taxable LTCG.

In Example 2, the AMT exemption would remain at $40,250 and phase out at the same levels as for a single taxpayer. S's tax liability on her ordinary income would be lower due to a higher standard deduction ($7,300) and the more favorable HOH tax brackets. Her Federal tax without the capital gain is calculated as follows:

AGI                          $80,000
Less: personnel exemptions     6,400 ($3,200 x 2)
Less: standard deduction       7,300
Taxable income               $66,300
Tax                          $12,095

Adding the LTCG into gross income and using the AMT calculation, without tax preference items, the total tax due would be:

AMT calculation:

Taxable income          $264,536
Addbacks:
  standard deduction       7,300
  personal exemptions      1,664 (partially phased out)
AMTI                    $273,500
Less: AMT exemption            0 (phased out)
Less: capital gain       193,500
AMT base                 $80,000

TMT                      $20,800 ($80,000 x 0.26)
Plus: capital gain tax    29,025
Total TMT                $49,825
Less: regular tax         42,304
AMT                       $7,521

The additional tax is $37,730 ($49,825 total tax payable--$12,095 tax payable before the LTCG is included). This increase raises the tax cost of the sale to approximately 19.5% ($37,730/ $193,500). This result is somewhat anomalous, however, as the usually favorable HOH filing status has a greater percentage increase in tax cost; the benefits of the higher standard deduction and the more favorable brackets are lost under the AMT, which treats all unmarried individuals similarly.

Example 3--MFJ: The facts are the same as in Example 1, except that S is married. In this case, the additional personal residence exemption would exclude most of the sale from tax, because the exemption for married tilers is $500,000, rather than $250,000. Accordingly, there would be no AMT due.

Example 4.--MFJ: The facts are the same as in Example 1, except that S is MFJ and sells securities at a $193,500 LTCG, rather than a personal residence, resulting in significant changes to the tax calculation.

There is a higher standard deduction for MFJ tilers ($10,000 for 2005), more favorable tax brackets, more of the personal exemptions remaining and a different AMT exemption. The AMT exemption for 2005 is $58,000 for MFJ, with a phaseout range of $150,000-$382,000 of AMTI (($58,000 x 4) + $150,000)).

The calculation of Federal tax before the sale is as follows:

AGI                         $80,000
Less: personal exemptions     6,400 ($3,200 x 2)
Less: standard deduction     10,000
Taxable income              $63,600
Tax                          $9,230

Including the $193,500 gain, the AMT calculation is:

AMTI                     $273,500
Less: AMT exemption        27,125 (partially phased out)
Less: capital gain        193,500
AMT base                  $52,875

TMT                       $13,748 ($52,075 x 0.26)
Plus: capital gain tax     29,025
Total TMT                 $42,773
Less: regular tax          38,959
AMT                        $3,814

In this case, the tax rate on the net taxable capital gain is approximately 17.3% ($33,543/$193,500). The additional tax would increase if the taxable capital gain were higher, because the AMT exemption is not yet fully phased out. Additional AMT will accrue until the upper limit of the phaseout is reached. Increasing the sale back to the original $300,000 of taxable LTCG in Example 1 results in the following:

AGI                         $380,000 ($80,000 + $300,000)
Less: personal exemptions          0  (fully phased out)
Less: standard deduction      10,000
Taxable income              $370,000
Tax:
capitol gain                  45,000 ($300,000 x 0.15)
ordinary income               10,830
Total regular tax            $55,830

The AMT calculation (without tax preference items) is:

AMTI                     $380,000
Less: AMT exemption           500 (partially phased out)
Less: capital gain        300,000
AMT base                  $79,500
TMT                       $20,670 ($79,500 x 0.26)
Plus: capitol gain tax     45,000
Total TMT                 $65,670
Less: regular tax          55,830
AMT                        $9,840

The total incremental tax on the $300,000 LTCG would be $56,440 ($65,670-$9,230), or approximately 18.8% of the LTCG. This is close to the upper limit of the current phaseout range and essentially illustrates the maximum additional tax that would be incurred through the interaction of the AMT and a taxable LTCG. Above the upper limit, the marginal rate returns to 15%, and the effect of the additional AMT is diminished as the gain increases. The AMT exemption for MFJ is scheduled to return to $45,000 for tax years beginning in 2006. If it does, the upper limit would be reached at $330,000 AMTI (($45,000 x 4) + $150,000), rather than at $382,000, as under the current regime.

Effects on Rate with Different Variables

Based or current effective tax rates, Exhibits 1 and 2 at right show the point at which the effects of LTCGs are most severe, depending on the filling status, ordinary income and LTCG at issue. For example, in Exhibit 1, ordinary income is held constant at $80,000 and the LTCG amount varies from zero to $1 million in $100,000 increments. Given $80,000 ordinary income, the effective tax rate escalates rapidly for a LTCG of approximately $100,000 and peaks at approximately $190,000 for unmarried taxpayers and at about $300,000 for MFJ. For larger gains, the effective tax rate decreases as the marginal rate returns to the maximum 15%. For $1 million LTCG, the effective tax rate is about 15.5% for singles. The single filer peaks at an effective rate of about 18.2%, while the HOH filer peaks at about 19.3%, and the MFJ filer at about 18.7%.

In Exhibit 2, the LTCG is fixed at $300,000, and the ordinary income varies from zero to $350,000, in $50,000 increments. Here, the maximum effective tax rates are reached at upper-middle-class income levels. The effective tax rate begins to recede from the maximum effective tax rate as the gain rises above $190,000. At very low levels of ordinary income, there is a reduction in the effective tax rate caused by the application of the 5% LTCG rate. The 5% rate phases out when total income reaches the end of the 15% regular tax bracket.

State and Local Taxes

The effect of state and local taxes on LTCGs varies considerably by jurisdiction. With the advent of the new sales tax or income tax deduction under the American Jobs Creation Act of 2004, it became even more complex. (3) Any substantial state income tax payment for a large LTCG would likely move a taxpayer into itemizing deductions for Federal income tax purposes. Generally, this would increase itemized deductions when computing regular Federal tax liability and, thus, would reduce such liability. Under the Federal AMT rules, state and local tax payments cannot be deducted and must be added back in arriving at AMTI. Most of the potential value of the state and local income tax deduction is lost via the AMT.

Planning Suggestions

When faced with the need to estimate the effect that large LTCGs may have on a client's tax obligations, tax advisers need to use the following guidelines. Initially, it is important to explain to the client that the AMT can readily raise the actual Federal tax cost beyond 15%. Often, even reasonably sophisticated taxpayers have some trouble grasping the fact that their LTCG will trigger a more-than-15% rate. However, taxpayers who are forewarned react far better when they see an AMT schedule attached to their return. As clients have varying combinations of ordinary income, deductions and LTCGs, there is no single tax rate estimate that will serve them all.

Exhibit 3 above presents Federal tax rate estimates for single, HOH and MFJ taxpayers at varying income levels and LTCGs (assuming standard deductions). The charts apply to the net taxable LTCG, which is the amount remaining after deducting any applicable personal residence exclusion. They should be used by multiplying the percentage shown in the chart by the LTCG. For example, if a MFJ couple with $100,000 ordinary income expects a $150,000 LTCG, the calculation would be 17.1% multiplied by $150,000, for an estimated $25,650 of additional Federal tax due. The usual 15% estimate would yield $22,500, $3,150 less than the correct amount. Exhibit 3 considers additional Federal taxes; any state and local taxes should be calculated separately. For ordinary income or LTCGs between the categories, a simple interpolation of the percentages will result in a reasonable estimate.

Practitioners in jurisdictions with state or local income taxes on LTCGs (particularly in high-tax states) need to increase the estimates of tax due by almost the full state and local tax rate percentage, because the AMT disallows the deduction. There is a potential advantage available to certain taxpayers if they do not pay the state or local tax on the LTCG in the tax year recognized, but in the beginning of the subsequent tax year. These taxpayers may still fulfill the estimated tax payment requirements of their local jurisdiction, but defer the Federal deduction into the subsequent tax year.

For example, if a taxpayer owes $10,000 in state tax on a LTCG recognized in 2005, that amount can be paid in January 2006. This defers the Federal deduction into 2006, which can provide a benefit that year that would essentially be lost had the Federal tax deduction for the state and local payment been taken in 2005. The AMT essentially negates the value of the deduction for any state taxes paid in 2005. Although this conflicts with the common wisdom that accelerating deductions is usually advantageous, the result may be more beneficial when the deduction is deferred.

Conclusion

This article illustrates the additional Federal taxes that may be due on a LTCG because of the AMT. Specific client tax situations are quite varied, but the use of Exhibit 3 will provide reasonable estimates of the additional taxes that may be due and will help tax advisers better serve clients with significant LTCGs.

EXECUTIVE SUMMARY

* Despite the lower capital gain rates and greater AMT exemptions of recent years, long-term gains can still increase exposure to AMT, depending on filing status and other factors.

* Tax advisers can provide clients planning sales, with an estimated percentage of the additional Federal tax that would be due on prospective LTCGs under different scenarios.

* By making state and local estimated tax payments in the year following a gain, certain taxpayers can also defer the Federal deduction to the following year, avoiding the negative effect AMT has on such deductions.

(1) For a discussion, see Hegt, "JGTRRA Cuts Rates, Increases Some Deductions and Credits," 34 The Tax Adviser 542 (September 2003).

(2) See Sec. 55(d)(1).

(3) For details, see Nissenbaum, "Significant Individual Provisions of the AJCA," 36 The Tax Adviser 92 (February 2005).

Charles Carslaw, M.A., CPA

Associate Professor of Accounting

Department of Accounting and Information Systems

College of Business Administration

University of Nevada

Reno, NV

Richard Mason, Ph.D., J.D.

Assistant Professor of Accounting

Department of Accounting and Information Systems

College of Business Administration

University of Nevada

Reno, NV

John R. Mills, Ph.D., CPA

Professor of Accounting

Department of Accounting and Information Systems

College of Business Administration

University of Nevada

Reno, NV

For more information about this article, contact Prof. Carslaw at [e-mail].

Exhibit 3: Estimating the Federal rates (in %)

                                Single filer

                                    LTCG
Ordinary income                (in thousands)
(in thousands)     $50   $100   $150   $200   $250   $300

      $50         15.0   15.0   15.7   17.2   17.4   17.0
     $100         15.1   16.0   17.8   17.9   17.3   16.9
     $150         15.7   18.2   18.2   17.4   16.9   16.6
     $200         15.8   16.7   16.2   15.9   15.7   15.6
     $250         15.3   15.2   15.1   15.1   15.1   15.1

                                    HOH

                                    LTCG
Ordinary income                (in thousands)
(in thousands)     $50   $100   $150   $200   $250   $300
      $50         14.3   14.7   17.0   18.3   18.2   17.7

     $100         16.8   19.1   19.9   19.5   18.6   18.0
     $150         21.5   21.5   20.4   19.0   18.2   17.7
     $200         22.0   20.2   18.4   17.6   17.1   16.7
     $250         18.3   16.7   16.1   15.8   15.7   15.8

                                    MFJ

                                    LTCG
Ordinary income                (in thousands)
(in thousands)     $50   $100   $150   $200   $250   $300

      $50          9.8   12.4   13.3   13.9   15.5   16.6
     $100         15.0   15.0   17.1   18.2   18.9   18.9
     $150         15.1   18.3   19.4   19.9   19.7   19.0
     $200         19.5   20.6   21.1   20.7   19.5   18.8
     $250         20.1   21.0   20.5   19.1   18.3   17.7