The Alternative Minimum Tax is a very important consideration for taxpayers who own real property because almost all of the tax rules that apply to real property are different for the AMT than for the Regular Tax. This article on Real Estate and the AMT will address those situations where the individual owns the real estate as an investment, usually as rental property. The differences in tax treatment between the Regular Tax and the AMT can be significant.
Interest expenses
The interest paid for the mortgage contracted to acquire the property is fully deductible, both from the Regular Tax and the Alternative Minimum Tax. Unlike itemized deductions that allow a tax benefit for what amounts to personal expenses, tax law generally allows all deductions a taxpayer has to make in pursuit of business income. Therefore, the limitations discussed in the previous article on home mortgage interest do not apply.
However, if the equity in the rental property is used as collateral for an additional loan, such as a second mortgage, then the taxpayer must see how the proceeds from that loan are used to determine the interest deduction. If the income is used for a car loan or to finance a child’s education, for example, then the interest is nondeductible personal interest. If the income is used to improve the rental property, the interest is deductible.
Tip: Taxpayers are better off keeping personal loans separate from business loans. Mixing the two creates record keeping challenges and can lead to disputes with the IRS.
property taxes
Property taxes paid on rental or investment properties are allowed in full for both Regular Tax and Alternative Minimum Tax purposes.
Planning Tip: If you have a chance to pay your property tax bill this year or next, do it in a year when you have enough income from the property not to create a rent loss. This strategy can help to avoid triggering the passive downtime limitations described below.
Example: In Florida, property tax bills are mailed in October and paid according to the following discount schedule: November: 4%, December: 3%, January: 2%, February: 1%. If you have a property loss in 2010 but expect to generate income in 2011, don’t pay your bill in November or December; Giving up that small discount could help you avoid stop-loss rules.
Depreciation
Depreciation is allowed for property held for investment. The part of the cost attributable to the land is not depreciable, but it is to the building itself and the furniture, electrical appliances, carpet, etc. a deduction may be taken for depreciation.
Real estate (this is the legal definition of a house or other building) held for rental/investment can only be depreciated for Regular Tax purposes under the “straight-line” method, over a useful life of 27.5 years. Therefore, a property with $275,000 allocated to the building would depreciate at the rate of $10,000 per year.
Personal property (this is the legal definition of things like furniture, appliances, rugs, and the like) can be depreciated for Regular Tax purposes under an “accelerated” method over a useful life of five years. An accelerated method allows for a larger depreciation deduction in the early years, in recognition of a factor of obsolescence or decline in value seen in new property (automobiles are a good example).
However, for AMT purposes, personal property can be depreciated only using a straight-line method. Thus, an AMT article will be generated in the first few years if the accelerated method is used.
Planning idea: For personal property, consider choosing the straight-line method for regular tax purposes. While you do give up a small tax benefit for higher depreciation in the early years, it could mean avoiding paying AMT.
Active/passive investment rules and “at risk” rules
A taxpayer who is not “active” in managing investment property cannot use rental property losses to offset other income such as wages and salaries, dividends, interest, capital gains, etc. Instead, these losses are deferred until the taxpayer sells the property or generates passive income from this or other passive investment sources.
The risk rules also deny the use of this type of loss to the extent that the taxpayer has acquired the investment with borrowed money and has no personal responsibility for the debt.
planning idea
If these loss limitations apply, consider the planning ideas above to minimize the losses that occur each year. They’re not doing you any good anyway.
Property sale
Several different AMT issues can arise in the sale of rental/investment properties. One is that your profit or loss may be different for AMT than it is for regular tax purposes. This would occur if different depreciation methods were used. For example, if personal property was depreciated using an accelerated method for Regular Tax purposes, then the basis on that property in calculating gain or loss on sale would be different because the straight-line method had to be used for Minimum Tax purposes. Alternative.
The gain on the sale of investment property is generally a capital gain, although a portion may be treated as ordinary income depending on the accelerated depreciation method used. Capital gains themselves are not an AMT item, but may nonetheless result in an AMT payment. This is because the AMT exemption amount phases out for taxpayers at certain income levels, so this additional income may result in a reduction in the exemption, which in turn increases taxable income for effects of the Alternative Minimum Tax.
