It was three years ago in April when he saw it – a little hole under the fence that separated his yard from Richman's. He said to himself, "Oh no. I'm not wealthy. How could this happen to me?" He quickly covered the hole with dirt and continued his regular gardening. When he saw it again the following April, the hole had grown to twice the size, but still too small to let the beast through. That's when he decided to visit that area of his backyard more often. He vowed to keep looking and filling the hole in the fall, before it got too close to April.

And so it is, with the beast known simply as "AMT."

The AMT is actually a "parallel" tax, running side by side with the regular tax. In fact, you might look at it as a second system that forces you to compute taxes twice: first, under the regular system; then again, using the AMT system. Unfortunately, we are forced to use the system that results in the higher tax.

Most of us are very familiar with the regular system. After totaling all sources of taxed income, we subtract our allowable deductions and personal exemptions to arrive at Taxable Income. We use the "graduated rate schedules" (starting at 10% and climbing to 35%) to determine how much tax we incurred on that Taxable Income. Some credits may be allowed to reduce this tax.

The AMT system is actually a little simpler. Most of the income that gets taxed under the regular system is also taxed here. However, there are fewer deductions allowed. After subtracting a special exemption, which is generally higher than the regular tax personal exemption, you arrive at an amount subject to the AMT. The tax rates applied in AMT never exceed 28%. Only the AMT Foreign Tax Credit may reduce this tax.

Since the top AMT rate is lower than the top regular tax rate, where's the problem?

While there is also a "phase-out" of itemized deductions for regular tax purposes, causing the loss of some deductions at higher income levels, the elimination of some deductions altogether for AMT purposes often will make AMT the higher tax system.

It is frustrating to realize that you have lost some or all of the benefits that having a tax deduction was supposed to derive.

So, what are the deductions that might "trigger" AMT?

There are a few itemized deductions that are not allowed for the AMT. Since, for the AMT, they must be "added back," Alternative Minimum Taxable Income ("AMTI") is ordinarily higher than regular taxable income. If it is much higher, then even the lower rate will not be enough to keep the AMT less than the regular tax.

For most taxpayers, the regular tax deduction for state and local taxes is the one that causes the biggest AMT problems. Included in this tax deduction are state and local income tax withholdings, estimated tax payments and other payments made with state or local income tax returns. (Beginning in 2004, taxpayers are allowed to use state and local sales taxes instead of income taxes.) Also included in taxes are real estate taxes paid on your home and investment property (but not rental or business property), and some other miscellaneous taxes. None of these deductions is allowed for the AMT.

Other commonly lost deductions are the ones jointly called "Miscellaneous Deductions." They include unreimbursed employee expenses, investment expenses, individual tax preparation and related tax filing costs, safe deposit fees, etc. When calculating the regular tax, they are deductible only to the extent that, when taken as a group, they exceed 2% of Adjusted Gross Income. Consequently, most taxpayers lose them even before considering the AMT. When calculating AMT, none of these deductions is allowed.

Those taxpayers who own businesses or rental property may find that some of the depreciation deductions that were taken for the regular tax calculation must be postponed for the AMT calculation. Unlike the previous two groups of lost deductions, the total deduction for AMT depreciation will eventually equal that of regular tax depreciation. However, it is usually calculated on a slower, more extended method. (Actually, after some years of this limitation, the AMT depreciation in later years will exceed that of the regular tax system, causing a "credit" which may lower overall taxes.)

The other deductions that may increase the AMT risk, although less common, are unusually high medical expenses and net operating loss deductions.

Other regular tax deductions – those that can be also deducted for the AMT – include charitable contributions, mortgage interest, business deductions and some others. Clearly, they are still valuable in the AMT... but, less so than if not. Rather than yielding the benefit at the regular tax rates, such deductions offer savings only at the lower AMT rates.

I hear that some investments may cause AMT. Which income items should I watch out for?

There are some income items that cause "tax preferences." Tax preferences, although the term sounds beneficent, are actually those items of income that will be added back to arrive at AMTI. In other words, "You may have preferred them when you were calculating regular tax, but you won't when you get to the AMT calculation."

In my experience, the one that surprises people most relates to municipal bonds. Of course, no one is shocked to learn that items relating to "tax shelters" (e.g., Intangible Drilling Costs) must be added back. After all, wasn't the AMT designed to trap rich people who "abused the system" by making those investments? And is it not also true that municipal bonds – representing money that you lend to your state or local government to help as a good citizen – are "tax-free"? How would you feel if you learned that the interest earned on those good-citizen bonds, interest on which you accepted lower yields in exchange for tax relief, were taxable after all?

As I stated in an article written in August 1995, entitled MUNICIPAL BONDS: Not Always Tax Exempt, the interest earned on some municipal bonds are considered tax preferences, which must be added back to calculate AMTI. Specifically, the adjustment must be made for "Private Activity Bonds" (used for a specified purpose, such as an Industrial Bond) issued after August 7, 1986. Nowadays, brokers commonly refer to these as "AMT Bonds" and hopefully know for whom these investments should not be held. (Note: The yields on AMT Bonds are often greater than non-AMT municipal bonds due to the problem for many taxpayers facing the AMT. Conversely, those who will avoid the AMT should be attracted to AMT Bonds.)

Other (less common) items of income that may generate AMT include incentive stock options and timing differences from passive activities.

Obviously, AMT can be a problem. I thought those deductions and income items are pretty standard. Is there anything else I have to watch?

If you derive a substantial portion of your income from foreign sources, you are probably aware that you will benefit from the Foreign Tax Credit. The stated purpose of this credit is to eliminate the possibility of double taxation. As a citizen or resident of the United States, you must pay US tax on income from all sources – foreign and domestic. Foreign income is often subject to income tax by the foreign country, generally through tax withholding "at source." For regular tax purposes, the credit allowed against US tax is the lesser of (a) the actual tax you paid to the foreign country or (b) the portion of US income tax directly related to the foreign income.

The AMT Foreign Tax Credit is calculated in much the same way, except that "the portion of US tax" includes only items that enter into the AMT calculation. The differences are often minor. The real problem is that the AMT Foreign Tax Credit is limited to 90% of the pre-credit AMT. (No such limit applies to the regular Foreign Tax Credit.) Consequently, when income is made up largely of items from foreign sources, this credit limitation will generally force the AMT to exceed regular tax.

I thought that the AMT only applied to rich people with million dollar incomes. Why are you telling me that it may also affect me?

A funny thing I've heard about politicians: All of them don't tell the truth all of the time.

Back in the "old days" before the Alternative Minimum Tax, there was just a "Minimum Tax" that placed a special add-on premium for items that were largely limited to tax-sheltered investments. It was not a "parallel system" like the AMT, and it did not affect the basic deductions that we have come to rely upon to lower our taxes. The Minimum Tax of old was ordinarily a tax on the high-income taxpayers, since others were not investing in tax shelters.

Over the years, through several administrations, our tax code has been amended and even rewritten to address the needs of society … and, of course, political pressures. Some of those changes, especially recent ones, have forced all of us to take a good look at the AMT.

Today the AMT system engenders an interesting "potbelly" effect. Whether or not our lawmakers intended it is not for me to say. However, its effect is clear: Those on the lowest and highest ends of the "income spectrum" escape the AMT, and those in the broad middle are trapped.

How could such a thing happen?

Actually, when you understand the AMT system, it isn't so hard to see. First of all, the basic AMT exemption is pretty high. Married people have a $58,000 exemption, and unmarried filers use $40,250. When you also consider that the add-backs for depreciation and municipal bond interest will probably not apply to those who have lower incomes, and that those same people probably are not paying much in state and local taxes, it becomes clear that the exemption is enough to shield them from the AMT.

As you review the middle group, you start to see that they usually have larger add-back items. What makes matters worse for someone in this group is that once his/her AMT income exceeds a threshold, which I'll refer to as the beginning of "Death Valley," the exemption begins to "phase-out" at the rate of 25% of the excess until it reaches zero. Death Valley begins for married people filing jointly at $150,000, for unmarried filers at $112,500, and for married people filing separately at $75,000.

Example 1:

A single individual with a basic exemption of $40,250 is left with no exemption when AMTI hits $273,500.
	[Phase-out = ($273,500 - $112,500) x 25% = $40,250.]
	[Exemption = $40,250 – $40,250 = $0.]

Example 2:

If AMTI were $200,000, the exemption would have been $18,375.
	[Phase-out = $200,000 - $112,500) x 25% = $21,875.]
	[Exemption = $40,250 – $21,875 = $18,375.]

While these levels of income for a single individual are pretty comfortable, they certainly would not be considered in the highest group.

The top group is made up of people whose incomes are high enough to have already left Death Valley. The chances are that their incomes are, in fact, well above the Valley's upper limits. Those outer limits are: married people filing jointly - $382,000, unmarried filers - $273,500, and married filing separately - $191,000. Once the exemption is already lost, then the additional income above those levels is taxed at 35% regular tax, while "only" 28% in the AMT. Eventually, the regular tax becomes the greater one. That's why higher-income taxpayers are generally not subject to the AMT.

Is it likely to change soon?

Not immediately, I'm afraid. Unlike regular tax exemptions and bracket levels, the AMT amounts have not been indexed for inflation. And unlike regular income tax rates, which, beginning in 2001, were reduced by 8% to 12% for most taxpayers who get caught in the "potbelly," the AMT rates were not reduced. These two additional factors make it likely that AMT is "here to stay" for many of us, unless Congress reverses the trend by conforming the AMT to changes in the regular tax.

Yes, net long-term capital gains (on capital assets held more than a year) and "qualified dividends" (most regular dividends from corporations) are taxed at no more than 15%. For those whose regular tax bracket on ordinary income would be below 25%, the tax rate for this special income will be as low as 5%.

Do I lose these benefits when I'm in the AMT?

The answer is a very simple "Yes, and No."

To preserve the benefits of this politically controversial tax relief, Congress added a provision that saves the 15% and 5% rates for capital gains and qualified dividends. Instead of multiplying the entire net income by the 26% and 28% AMT rates, first we remove capital gains and dividends, which are taxed at their lower rates, and then only the remainder is taxed at AMT rates.

While that provision keeps all the benefits for some people, it does not fully preserve them for those in Death Valley. Capital gains and qualified dividends are still considered income, and so they contribute to the phase-out of the exemption amount. This raises the effective rate on other income subject to AMT. As stated earlier, those not in Death Valley – in the lowest and highest income groups – are not affected by the phase-out.

The key to taming the AMT beast is planning for it. And it is better to plan before the year ends than after. Depending on your specific circumstances, you may be able to use one or more of these tried-and-true strategies:

DEFER DEDUCTIONS FOR AS LONG AS POSSIBLE, PARTICULARLY THOSE THAT ARE NOT DEDUCTIBLE FOR AMT.
The one that comes to mind first is the payment of state and local income taxes. If you pay estimated taxes, the fourth quarter installment is generally due on January 15 of the following year. While it is common practice to pay that installment by December 31, so as to accelerate a Federal tax deduction, doing so when facing the AMT will be to no avail. It is better to wait until its normal due date in January in the hopes that you will not be subject to AMT in the following year and will deduct it in full then.

The same can be said for any balance you expect to owe your state or city on April 15. If you're going to be in the AMT for this year, you might as well wait until the April deadline to pay it.

Often real estate tax bills get mailed shortly before year-end. If the due date for paying is in January, then these too should be deferred.

SLOW DOWN DEPRECIATION DEDUCTIONS.
Taking accelerated depreciation is usually a good strategy to minimize taxes. However, you might as well take a straight-line, extended-period deduction if the AMT is a real concern, since your deduction will be limited anyway, and you will depreciate your property longer.

ACCELERATE INCOME.
? What? Take taxable income earlier than I have to? What about the "Present Value" of Money?

Yes, I realize this seems backwards. However, if you are in the AMT in the current year, you'll be paying at a top rate of 28%. If you expect not to be in the AMT next year, your rate in that year may be as high as 35%. Therefore, you can gain 20% of the tax (7% divided by 35%) by accelerating it. While the "Present Value" of money usually shows the advantage of deferring payments as long as possible, chances are you would not be able to earn a 20% rate of return on the postponed tax.

Many people ask their employers to put off year-end bonuses until January. Others send out billing to customers late so as to defer collections. These should be reexamined in light of the AMT.

Caution: Acceleration of income in this manner only makes sense when you expect NOT to be subject to AMT in the FOLLOWING year.

LOOK FOR MUNICIPAL BONDS THAT ARE NOT AMT BONDS.
Although AMT bonds generally yield more than non-AMT bonds because of the tax premium paid on the former, if you're in the AMT, you should stay away from AMT bonds, since on an after-tax basis, they will yield less.

Of course, this is not intended to be investment advice in general. And I strongly recommend that you speak to your investment advisor about other important factors entering into the decision of buying municipal bonds (stability, ratings, etc.). Fortunately, there are many bonds available from which to choose.

According to my tax professional, I am likely to remain subject to the AMT, year after year. Since postponing deductions or accelerating income won't help me, what can I do?

Unfortunately, there is not much else to do.

It may not be a practical solution, but if you happen to be considering leaving the state where you live and/or work, you should know that there are some states that have no income tax, and maybe some that have tax rates lower than yours. By living and working in a no-tax state, you not only reduce your state and local tax burden, but also will find yourself less likely to fall into the AMT, since a common cause of AMT is the add-back of these taxes. The following states presently have no income tax:

• Alaska
• Florida
• Nevada
• South Dakota
• Texas
• Washington
• Wyoming
• In addition, New Hampshire and Tennessee tax only dividends and interest.

Despite the tax professional's prediction, you may find that in the future you will not be subject to AMT. Anything could happen – a tax law change which eases the problem that is causing your AMT, or you could hit the lottery and thus be in the top income group, or...

Life is full of surprises, so why not follow the strategies I laid out - just in case?

Every fall he went to the hole under the fence between his yard and Richman's, knowing that it would be larger than it had been the year before. Each year he brought more dirt to fill it, and so far he has kept the beast out. After all, the yard is all he has. He says to himself, "It's just a matter of time."