In May 2001, President Bush signed a tax-cut bill that, perhaps unwittingly, widened the scope of an expensive challenge facing taxpayers and their financial advisors. That challenge is the Alternative Minimum Tax.

The AMT is a separate tax computation that eliminates many deductions and exemptions and counts as taxable income the interest received from some tax-exempt bonds. Prior to the new tax code, by the year 2010 the AMT was projected to hit 17 million people, or 16% of all taxpayers. The new projections for 2010-reflecting the new tax law-say the tax will hit 35 million people. Paradoxically, the tax cut will sharply increase the number of AMT taxpayers because it will reduce their regular income tax liability below the point where the AMT kicks in.

This doubling in the number of AMT taxpayers will boost the attention paid to managing AMT tax liability. Among the beneficiaries will be members of that select group of municipal bond funds that restrict themselves to non-AMT bonds-the funds whose distributions are entirely free from AMT.

Ironically, the Bush tax cut contains a provision euphemistically referred to as AMT relief. Legislators have been under pressure to "do something" about the growing AMT problem, so they increased the AMT exemption by a nominal amount. On a joint return, the increase is $4,000, to $49,000, and on an unmarried return, it's a $2,000 rise to $39,750.

The increase is only for the years 2001 through 2004; in 2005 the exemption drops back to the old level. Meanwhile, decreased marginal tax rates will be phased in. The result of these changes is a huge jump in 2005 in the number of AMT taxpayers from 5.3 million to 13 million, according to Congress' Joint Committee on Taxation. So much for AMT relief. Congress sadly squandered this opportunity to fix the problem.

In the last few years, the unpopular AMT has taken a pounding in the press and in congressional hearings. Tax professionals deplore the AMT, and in January 2000, even the IRS' Office of the Taxpayer Advocate proposed repealing it. The AMT calculation is convoluted, and there is a high degree of AMT tax-bracket creep. Millions of people considered middle-class have become AMT taxpayers because AMT tax rates and exemptions are not indexed for inflation or real income growth, as well as because of the "alternative compensation" stock-option boom. Paper profits from the exercise of incentive stock options are subject to AMT, even if the stock price subsequently declines, unless the shares are sold before December 31 of the year the options were exercised.

AMT hit about 1 million individual returns filed for 1999. For high-income individuals, AMT has already become common. In 1998 (the most recent year for which full statistics are available), 16% of tax returns with AGI in excess of $200,000 were subjected to AMT. Though AMT is mostly a problem of high-income taxpayers, about 27% of the affected returns in 2000 reported AGI of less than $100,000. It now falls hardest on those with incomes from $147,000 to $373,000, according to Citizens for Tax Justice.

In practice, AMT mainly affects taxpayers who receive significant income from sources other than ordinary income. These include capital gains, employee benefits and incentive stock options. Retirees with large proportions of investment and pension income are classic candidates. As state and local taxes rise over time with rising incomes, the itemized deduction of those taxes adds to the amount of AMT-preference items and tends to push taxpayers into paying the AMT.

On the AMT tax form (IRS Form 6251), a slew of deductions, exemptions and certain forms of tax-exempt income are dubbed "preference items" and must be added back to taxable income. One of those preference items is interest on "private-purpose" municipal bonds (other than qualified 501(c)(3) bonds) issued after August 7, 1986. The Tax Reform Act of 1986 called for tax-exempt bonds to be classified into two categories: public purpose and private purpose. Interest received on private-purpose municipal bonds was classified as a tax-preference item and therefore is subject to AMT. Most project bonds, such as those funding housing, student loans, airports and industrial projects, are classified as private-purpose bonds.

Ever since the 1986 Tax Reform Act, for every tax-exempt bond, a tax attorney must provide an opinion stating whether or not the interest on the bond is a tax-preference item and therefore subject to AMT. That opinion is printed on the cover of the bond's offering statement.

For AMT taxpayers, the result of the private vs. public distinction is of major importance. AMT municipal bonds have no appeal to someone who faces the AMT for even a short period, because this taxpayer could pay a 28% tax on his or her municipal interest income. There are two AMT tax rates: 26% on the first $175,000 of income and 28% on all income over $175,000. For AMT taxpayers, their effective tax rate is nearly equal to their marginal tax rate. AMT municipal bonds typically pay only 0.15% to 0.2% more interest than comparable non-AMT bonds-not nearly enough compensation for the AMT tax bite.

Many municipal bond funds hold AMT bonds, which means they distribute AMT income to their shareholders. In some municipal bond funds, more than 25% of the portfolio consists of bonds paying interest that-for an AMT taxpayer-is taxable. It is unlikely that AMT taxpayers will want to continue owning bond funds that pay AMT interest.

To determine what percentage of a fund's distribution is subject to AMT, check the fund's tax information brochure, search the company's Web site, call its customer-service line or check Morningstar Principia Pro. Morningstar asks each fund to disclose its proportion of AMT bonds, but not every fund provides Morningstar with an answer. A few funds specifically market themselves as nearly or completely non-AMT.

Municipal bond funds are required to distinguish AMT and non-AMT income on annual tax forms mailed to shareholders. The AMT income is a "tax-preference item" that must be added to taxable income on the AMT form so that it can be taxed at the AMT rate. Thus, AMT taxpayers should run, not walk, from bond funds that own more than 20% or so in AMT bonds.

Figure 3 shows the AMT cost over a range of possible exposures. It is easy to see that even a 25% exposure to AMT paper in a municipal bond fund will erase any yield advantage for an AMT taxpayer that a typical group of AMT bonds could give to the fund.

It's important to understand that tax-exempt funds that avoid AMT bonds are likely to sacrifice a little yield-on the order of 10 to 20 basis points (0.1% to 0.2%). For potential AMT taxpayers, it's a sacrifice that pays well.

Josh Gonze is an associate portfolio manager at Thornburg Investment Management Inc. in Santa Fe, New Mexico. He can be reached at (505)954-5211 or [email protected].