THE AMT AND WHAT IT MEANS
TO TAX-FREE BOND BUYERS

Do you own bonds that are subject to the Alternative Minimum Tax (AMT)?

Recently, it has become an issue for many investors, and experts predict that the number of people paying the AMT will grow rapidly.

The AMT was originally created in 1969 to prevent a select few wealthy Americans from avoiding income tax payments. It is a flat tax of 26% or 28%. It was enacted after Congress determined that there were hundreds of Americans earning more than $200,000 per year who paid no income tax. Congress responded by creating the AMT.

Each year, taxpayers who may be subject to the AMT must determine their tax liability by both the regular as well as the AMT method, and they are required to pay the higher of the two amounts.

The problem today

The problem today with the AMT is that income levels at which the AMT kicks in have not been sufficiently adjusted for inflation. As a result, millions of taxpayers with relatively modest incomes don't even know the tax exists and could become subject to it over the next few years.

Currently, more than 2.4 million taxpayers fall into the AMT category and this figure is expected to grow dramatically. In fact, the Tax Policy Center estimates that the AMT will affect 33 million taxpayers by 2010.

Calculating the AMT

The AMT is calculated by adding certain adjustments and tax preference items to the taxpayer's taxable income and then subtracting the exemption ($40,250 for single filers and $58,000 for joint returns) from the total income figure. The resulting figure is compared to the taxpayer's regular tax liability and the higher of the two must be paid.

Some of the adjustments added into the AMT calculation include state and local income taxes, real estate taxes, and miscellaneous and standard deductions.

Preference items include passive losses from partnerships, exercising of incentive stock options and interest from municipal bonds subject to AMT and AMT bond funds.

As previously mentioned, taxpayers are permitted to reduce the AMT income by the "exemption amount" before calculating the tax due. The exemption amount, however, begins to phase out if AMT income exceeds certain thresholds and is eliminated entirely if AMT income reaches $382,000.

It is generally recognized on Capitol Hill that unless something is done, the AMT will have a dramatic impact on middle class taxpayers that was unforeseen and unintended when it was enacted.

Although there are no less than a dozen bills pending in Congress directed at reform or repeal of the AMT, it is unlikely that there will be any major changes in the law. The AMT simply produces too much revenue for the U.S. Treasury.

Tax-free bonds and the AMT

The interest from some tax-exempt bonds becomes subject to taxation for AMT taxpayers. These "private activity" bonds are issued for purposes as diverse as health care, housing, airports and football stadiums. In the industry, they are known as AMT bonds and are easily recognized because FINRA regulations require an AMT disclosure on the investor's confirmation of purchase.

AMT taxpayers must be aware that the income from these bonds is not excluded from the AMT calculation and, after accounting for the income exemption, can become fully taxable. Regular taxpayers are not subject to taxation on their income from AMT bonds. (Non-AMT bonds are federally tax exempt regardless of the tax paying method utilized.)

What's a bond investor to do?

It is extremely important to consult your tax advisor before purchasing municipal bonds that are subject to the AMT. Your discussion should not only include your current status, but your likelihood of becoming subject to the AMT in future years.

If you own AMT bonds today and expect to be subject to the AMT in future years, consider converting some of your AMT bond holdings to bonds not subject to AMT. (You will probably have to sacrifice some income to accomplish this.)

If, as the Tax Policy Center predicts, many more people become subject to the AMT, it would be logical that the yield spread between AMT and non-AMT bonds would widen, making the conversion process more expensive in ensuing years.

If you find yourself in this situation, you may want to consult a tax-free bond specialist to assist you in exploring your options.

3/31/04