The AMT and 1031 Exchange
How a 1031 exchange may save investors more than just taxes owed on capital gains.
By Adam Skarsgard, Esq., CPA
For many taxpayers, the Alternative Minimum Tax (AMT) is a source of considerable confusion and consternation. While very little of our current federal tax system is coherent to the average taxpayer, the AMT surely is the most confusing and difficult to absorb. Your author in fact hesitated in writing this article due to the difficulties in explaining the system. However, the issue is so important; I do want to make an attempt. We will first look briefly at the Alternative Minimum tax and how it works. We will then explore the ways in which a 1031 Exchange can help affected taxpayers minimize their AMT tax bill.
What is the AMT?
The AMT is a system of taxing income completely separate from the normal system to which we have all become quasi-accustomed. Your tax preparer essentially figures out your taxes owed using both the traditional system and the AMT. Whichever system produces a larger tax owed is the system that will be used. You would not expect it to be the other way around, would you? The AMT, established in 1969, was initially instituted to help assure that the very wealthiest taxpayers did not escape paying their fair share due to clever loopholes. In fact, according to Tax Foundation, a non-partisan tax research group in Washington, the AMT was initially deemed necessary because Congress found out that 155 taxpayers with income over $200,000 had not paid income taxes in 1967 due to tax loopholes that were legal at the time. While the initial AMT affected just a few thousand people in 1970, today it affects literally millions. The reason more and more people are paying taxes pursuant to the AMT is that unlike the traditional system which is indexed each and every year to account for inflation, the AMT is not. The AMT system has undergone a few changes, but nothing major since its birth in the late 60’s.
How does the AMT Work?
In general, the AMT forces you to add back some of the deductions you have come to know and love under the traditional system: such as, your personal and dependent exemptions, your home equity loan interest, your state, local and property taxes, and some medical and dental expenses. There are other deductions that are added back, so check with your tax advisor. After all of the aforementioned deductions are added back, the AMT allows for an exemption of $62,550 for married couples and $42,500 for singles. The final step is determining whether your adjusted income, minus all of your favorite deductions, is more than your exemption. If so, you will pay tax on the difference using one of two tax rates, depending by how much you exceeded your exemption.
The AMT and 1031 Exchange
Taxpayers affected by the AMT are still taxed on capital gains at the maximum federal rate of 15%. The AMT does not affect the tax paid on capital gains. However, doing a 1031 Exchange may help you in another, commonly forgotten way. In the above section, it was mentioned that each AMT taxpayer has an exemption of either $62,550 or $42,500. What was not mentioned is that those exemptions are reduced if your taxable income exceeds a certain amount. For married taxpayers, the exemption is reduced by 25 cents ($.25) for each dollar of AMT income over $150,000. For singles, the cutoff is $112,500.
So while the AMT will never increase the taxes you pay on capital gains, the additional income recognized as capital gain could push you over the exemption threshold and therefore reduce your exemption. If you do the math in such a scenario, each dollar of capital gain will cost you approximately 10 cents ($.10) in additional taxes under the AMT. However, for taxpayers who perform a 1031 Exchange, the additional income will not be recognized, and thus the gain will not increase the taxes paid under the AMT.
The AMT is a confusing pain in the pocketbook for an increasing number of taxpayers. Although the AMT does not increase taxes on capital gains, such gains can reduce a taxpayers AMT exemption, which will increase their taxes on income. Investors who instead perform a 1031 Exchange will not only avoid paying capital gains taxes, they will also help preserve their AMT exemption and pay less income tax. In this sense, a 1031 Exchange can help you save on both capital gains taxes AND ordinary income taxes.
This article was written and prepared for informational purposes only and is not intended to provide tax or legal advice. Please always consult your tax advisor for specific guidance.