For the year 2000 26% of all taxpayers with income in the $200,000 to $500,000 range had to pay the AMT, according to a study by the U.S. Treasury. Only 1% of taxpayers with income in the $50,000 to $75,000 range were caught by the AMT.  It is estimated that by 2010 98% of those in the "wealthy" group and 18% in the latter group will have to contend with AMT.  In terms of numbers of taxpayers, by 2010 it is estimated that 35 million will be caught, about double the number before the passage of the new tax relief act.

This is an interesting result. Supposedly the Economic Growth and Tax Relief Reconciliation Act lowered tax liabilities, we thought. The Act raised the exemptions that may be claimed against the AMT: from $45,000 to $49,000 for joint filers, from $33,750 to $35,750 for singles, and from $22,000 to $24,000 for marrieds filing separately. The rate of tax that applies to the first $175,000 of AMT is only 26% and the rate thereafter is 28%. So, what's the problem?

First, these exemption increases expire after 2004. Second, more and more these days, high tax states are continuing to throw taxpayers into AMT status. Why? Because all itemized deductions for taxesþstate income, foreign income, real estate, car excise, and personal property taxesþare not allowed as a deduction in figuring the AMT. Third, before the stock market swoon, a lot of taxpayers were dealing with valuable incentive stock option (ISO) plans. If a taxpayer exercised an ISO, the difference between the fair market value and the exercise priceþthe so-called "bargain" elementþ was taxable for AMT purposes only. A taxpayer doesn't have to sell the stock to get himself stuck in an AMT situation. Mere exercise is enough.

In the Klaassen case, decided by 10th Circuit Court of Appeals, the Court ruled that the Klaassen's were liable for the AMT, even though their taxable income was only $34,000. Why? Because they had 10 chldren and a total of $29,400 in personal exemptions. Personal exemptions are not an allowable deduction in computing AMT income. Neither is the standard deduction, passive activity losses of any amount, medical and dental expenses under 10%, interest on any mortgage balance which exceeds the original home acquisition mortgage, and a host of other adjustments and tax preferences.

Also hit are taxpayers who have large unreimbursed business expenses, investment management and advisory fees, large hobby losses, attorney's fees, and any and all other miscellaneous itemized deductions.

What are some of the strategies that can used to deal with the AMT problem? Let's look at a few.

Increase Ordinary Income
Taxpayers may benefit by shifting bonuses, pay increases, short-term capital gains, and any other ordinary income into the AMT year. Why, since deferral is usually the best tax strategy? Maybe it still is. You have to "run" the numbers. What accelerating income into a current year does is to have the income taxed at an AMT rate of 26% or 28%, whereas the taxpayer may have been in the top regular tax bracket. You have to be sure there is enough tax saved to justify paying a tax one year or more early. As the saying goes, don't try this at home aloneþif you don't have a computer and a tax software program.

Deferring Itemized Deductions
Certain itemized deductions are not deductible when computing the AMT. These are all state taxes, home equity interest or interest on loan balances above acquisition debt (see below), all miscellaneous itemized deductions over the 2% adjusted gross income threshold, and medical expenses to the extent they exceed the 7.5% threshold but not in excess of 10% of adjusted gross income. To the extent possible, payment of these expenses may be deferred until the following year, if there is a benefit to doing so.

Alternate State Tax Payments
Since state taxes are not deductible, the question arises whether the payment of them can be timed so as to fall in every second year. State taxes include real estate taxes, income taxes (withholding and estimated), car excise taxes, and personal property taxes. If the taxpayer files quarterly state income tax estimates, could they be curtailed every other year and would there be any tax savings resulting from that strategy? To answer that question, estimates of tax liability must be madeþthe numbers must be runþon the two years involved. As to wage withholdings, if a taxpayer has some control over his or her state income tax withholdings, by virtue of being an owner of a business, could those withholdings be timed so as to fall in every second year, and what is the benefit? Remember that the effect of underpayment of state estimated tax penalties must be taken into account. This strategy may continue to be an alternative only so long as interest rates remain relatively low.

Investing In Muncipal Bonds
As everyone knows, interest on municipal bonds is exempt from regular income tax. However, interest on municipal bonds which fund a private activityþsay for example an industrial parkþare taxable for AMT purposes. In other words, the interest on those bonds must be added to regular taxable income specifically for the purpose of computing alternative minimum taxable income (AMTI). If a taxpayer is in an AMT situation, he or she must now consider the after-tax return alternative between taxable bonds, exempt municipal bonds, and private activity muncipal bonds. The often overlooked fact is that for taxpayers in the highest regular marginal tax brackets who now find themselves subject to AMT, the highest AMT tax rate is "only" 28%. It may be that a taxable bond will yield the highest rate of after-tax return.

Avoid Remortgaging The First Or Second Home in Order to Take Out Equity
Only interest paid on a loan used to purchase, build or substantially improve a taxpayer's principal residence and is secured by that residence is deductible for the specific purpose of computing AMT.
That means that the interest on most home equity loans (not used to build or substantially improve a residence) or on any loan balance in excess of the original acquisition loan must be added back to taxable income in computing AMT.
 
The strategy to avoid this result may be to borrow on stocks or other investment property. However, the problem with this strategy is that there is a limit on the amount of deduction for investment interest expense. It is limited to the net investment income. Net investment income is the excess of investment income over the actual deduction from investment expense, ie. the amount in excess of the 2% miscellaneous itemized deduction adjusted gross income limitation. Investment income includes gross interest, dividends, annuity income, royalties not from a business, gains from assets producing these types of income, short-term capital gains, working oil and gas interests treated as nonpassive, and net long-term capital gain gains to the extent elected to be treated as such. The penalty for making that election is a give-up of the favorable capital gain rates.

Exercise Incentive Stock Options in Same Year As Sale
The excess of the fair market value over the strike price or exercise price of an incentive stock option is an AMT taxable item. It is not taxable for regular tax purposes. There are several strategies to eliminate or minimize this type of AMT preference income. The first one is to simply "run the numbers" or project what the tax situation will be, given exercise of a certain number of options. Exercise only that number of shares which will keep the AMT at bay. Continue to stagger exercises over a number of years, all avoiding an AMT situation. The second strategy is to exercise the option at a point in time when the stock price is likely to be at its lowest level. The third strategy is to sell the options in the year of exercise. This is a strategy that must be validated by "running the numbers" to be sure that there is not too much of a "give-up" of tax savings from long-term capital gain rates.

A caveat to any option tax strategy is to put the investment fundamentals first and foremost. More money can be lost by ignoring the investment aspects then by losing a few tax dollars.