AMT and Long-Term Capital Gain

The problem: for high-income taxpayers, a large, long-term capital gain can trigger liability under the alternative minimum tax, or AMT. There’s no reason to believe Congress intended the AMT to apply merely because you have a long-term capital gain. Capital gains aren’t preferences, the term for tax benefits that get clawed back under this tax. In fact, the law provides that the lower rates for these gains (and for qualified dividends) apply under the AMT as well as the regular income tax. The way it works out, though, you may still pay AMT because of a large long-term capital gain. Here’s why.

The AMT exemption

As part of the AMT calculation, we’re allowed to claim a special deduction called the AMT exemption. The idea here is to prevent the AMT from applying to taxpayers with modest income. As of 2022 the exemption amount is $75,900 if single and $118,100 if married filing jointly.

Congress didn’t want high-income taxpayers to claim this deduction, so the exemption gets phased out at 25 cents on the dollar when income rises above specified levels: $539,900 for singles and $1,079,800 for couples (again, for 2022). The AMT exemption is sheltering part of your income from being taxed under the AMT system, so when it becomes smaller, the amount of income being taxed gets bigger. A reduction in this exemption is what causes a long-term capital gain to trigger AMT.

Let’s look at an example

Suppose you’re single, with income of $550,000. You cash in an investment for a long-term capital gain of $100,000. At today’s maximum capital gains rate, your regular income tax goes up by $20,000. The same rate applies under the AMT system, for an added $20,000 there as well. So far, so good, because AMT is based on the difference between the two calculations. There’s no problem when they both change by the same amount.

But the capital gain also reduces your AMT exemption by $25,000 (25 cents on the dollar). The exemption was shielding income that would otherwise be taxed at 28% under the AMT rules. So now, in addition to $20,000 in capital gains tax, the AMT calculation increases by another $7,000 (28% times $25,000).

You may or may not have to fork over $7,000 in alternative minimum tax when this happens. Various other factors can affect the amount you pay, if any. Yet this is how a large long-term capital gain can thrust you into the unpleasant and often costly world of AMT. Your regular income tax goes up by the capital gains tax; your alternative minimum tax goes up by the capital gains tax plus the tax cost of phasing out the AMT exemption.

Pain level

As the example above shows, the potential pain from this phase-out effect is 7 percentage points. That’s because the AMT exemption phases out at the rate of 25 cents for every dollar of added income within the phase-out range. The AMT tax rate is 28%. Multiply 28% times 25 and you get 7. The upshot is that the total tax cost of your long-term capital gain may be 27% instead of the 20% you might expect.

In theory it could be worse. If you’re able to deduct state income tax you pay on your capital gain, you may pay additional AMT because the  deduction won’t be allowed in figuring that tax. Nowadays, though, you’ll almost surely have maxed out your ability to deduct state income tax long before you see your AMT exemption start to phase out, so you aren’t likely to encounter this added effect.

More bad news

There’s more bad news. The AMT credit, which can ease the pain of having paid AMT, usually doesn’t apply to people who get caught by the AMT because of a large long-term capital gain. Typically this added tax is just a dead loss.

What to do

In many cases there isn’t a lot you can do about this added tax. Sometimes, though, if you’re aware of the issue, you may be able to take measures to reduce the impact.

Timing your capital gains

In some situations you can control the year in which you report capital gains. You may be able to delay a sale until after the end of the year, or spread the gain over a number of years by using an installment sale. There’s no simple answer to whether these measures help or hurt, so someone has to sharpen a pencil and grind out some numbers.

For example, your gain may be at a level where spreading it over a number of years will keep you out of the AMT — or at least reduce the impact. In this case an installment sale might be an attractive alternative. But suppose your gain is so large that it will phase out your AMT exemption amount many times over. In this situation, you may get a better result by reporting all the gain in one year, so it affects only one year’s exemption amount.

Timing other items

Another way to plan for the AMT is to see if you can change the timing of other items that are affected by the tax. For example, if you make estimated payments of state income tax, you may try to schedule your payments so they don’t fall in the same year as your large capital gain. In some cases you may come out ahead even if you incur a small penalty for being late with your state estimated payment.