The passing of the new tax laws lowering the federal capital gains tax rate from 20% to 15% was met with broad enthusiasm. On the surface this looks like a great benefit and a good excuse to consider taking some gains on long term assets with very low basis. Unfortunately, there is one giant fly in the ointment here that may make you want to pause a bit before you consider taking those gains. It’s the AMT, alternative minimum tax. While the new laws did adjust the alternative minimum tax somewhat, the lowering of the capital gains rate makes it likely many of us will feel the AMT's unpleasant impact.

First let’s review what the AMT is. It was established in 1969 with the intent to ensure that everyone pays at least some tax. The basic idea was that for the purposes of computing the AMT certain deductions would be disallowed and then a flat rate of either 26% or 28% (depending upon income) would be applied. This actually worked quite well for sometime until general incomes rose and more and more "regular" taxpayers were impacted. Because the AMT has never been indexed to accommodate higher wages and dual income families, it now tends to impact those for whom the original tax was never targeted. Single filers making more than $112,000 and couples filing jointly with more than $150,000 in income must calculate their AMT. While filers may benefit from some exemptions, those exemptions phase out as your income rises. Large capital gains that get added to your income can push your exemptions lower and the AMT tax higher.

As a rule of thumb, anyone who itemizes deductions and has income over the AMT thresholds will want to pay attention to a potential AMT liability when triggering any substantial long-term capital gains. If your regular tax liability is close to the AMT tax level then anything beyond a modest increase in long-term capital gains will be taxed at the AMT rates of 26% or 28%. What about the 15% rate? It’s irrelevant as far as the AMT is concerned. The IRS requires you to pay the higher of the regular or alternative minimum tax. Why wasn’t this as big an issue before? Because when the capital gains tax rate was 20% for most people the combined federal and state taxes where not far off the AMT rate so it took quite a lot of gains to trigger the AMT, and when it did the difference wasn’t as great. Now the disparity is bigger so relatively speaking long term capital gains will get you to the AMT faster and it will cost you comparatively more. This ‘penalty" is particularly onerous for those who sell very low basis stocks or anyone who might sell their primary residence and have a gain in excess of the home sale gain exclusion.

The message here is don’t run off taking long term capital gains assuming you’re only paying a 15% tax. Maybe you are but maybe you’re not. You’ll need to consult your accountant to be sure you are not going to be impacted by the AMT. If you are going to be subject to the AMT then you will want to incorporate the tax considerations into your thinking. In addition, if you anticipate the need to take large gains, you may want to consider if timing strategies might be appropriate to help minimize the tax impact. Until the AMT is thoroughly reworked or repealed, I’m afraid it’s going to be increasingly a part of tax and investment planning.

As always, please feel free to call if you have any questions.

Randy Gridley

June, 2003