Real Estate and the AMT: Rental Or Investment character
The different Minimum Tax is a very important consideration for taxpayers who own real estate because just about every tax rule applying to real estate is different for the AMT than it is for the Regular Tax. This article on Real Estate and the AMT will address those situations where the individual holds the real estate as an investment, typically as rental character. The differences in tax treatment between the Regular Tax and the AMT can be meaningful.
Interest paid on the mortgage taken out to acquire the character is fully deductible, both for the Regular Tax and the different Minimum Tax. Unlike itemized deductions that allow a tax assistance for what amounts to personal expenses, the tax law generally allows all deductions a taxpayer has to make in the pursuit of business income. consequently, the limitations discussed in the past article on home mortgage interest do not apply.
If, however, the equity in the rental character is used as security for an additional loan – a second mortgage, for example – then the taxpayer must look to how the proceeds of that loan are used to determine interest deductibility. If the proceeds are used for a car loan or to finance a child’s education, for example, then the interest is nondeductible personal interest. If the proceeds are used to enhance the rental character, the interest is deductible.
Suggestion – it is best that taxpayers keep personal borrowings separate from business borrowings. Mixing the two creates recordkeeping challenges and can consequence in disputes with the IRS.
character taxes paid on rental or investment character are allowed in complete both for Regular Tax purposes in addition as for the different Minimum Tax.
Planning idea – if you have an opportunity to pay your character tax bill either this year or next, pay it in a year when you have enough income from the character so as not to generate a rental loss. This strategy can help avoid triggering the passive activity loss limitations described below.
Example – in Florida character tax bills are mailed in October, and are payable under the following discount schedule: November – 4%, December – 3%, January – 2%, February – 1%. If you have a loss from the character in 2010 but expect to generate income in 2011, do not pay your bill in November or December – forgoing that small discount could help you avoid the loss-limitation rules.
Depreciation is allowed for character held for investment. The portion of the cost allocable to land is not depreciable, but for the building itself and the furniture, appliances, carpeting, etc. a depreciation deduction may be taken.
Real character (this is the legal definition of the house or other building) held for rental/investment may only be depreciated for Regular Tax purposes under the “straight-line” method, over a useful life of 27.5 years. consequently, a character with $275,000 allocated to the building would be depreciated at the rate of $10,000 per year.
Personal character (this is the legal definition of things such as furniture, appliances, carpeting and the like) may be depreciated for Regular Tax purposes under an “accelerated” method over a useful life of five years. An accelerated method allows a larger depreciation deduction in the early years, in recognition of an obsolescence or decline-in-value factor that you see in new character (cars are a good example).
For purposes of the AMT, however, personal character may be depreciated only by using a straight-line method. consequently, an AMT item will be generated in the early years if the accelerated method is used.
Planning idea – for personal character consider electing the straight-line method for Regular Tax purposes. While giving up a little tax assistance from the greater depreciation in the early years, it could average avoiding paying the AMT.
Active/passive investment rules and the “at-risk” rules
A taxpayer who is not “active” in managing investment character may not use losses from rental character to offset other income such as salaries and wages, dividends, interest, capital gains, etc. Instead, these losses are deferred until the taxpayer either sells the character or generates passive income from this or other passive investment supplies.
The at-risk rules similarly deny using these types of losses to the extent the taxpayer has acquired the investment with borrowed money and does not have personal liability on the debt.
If these loss limitations apply, consider the planning ideas mentioned above to minimize the losses being generated each year. They are not doing you any good anyway.
Sale of the character
Several different AMT issues can arise on the sale of rental/investment character. One is that your gain or loss may be different for the AMT than it is for Regular Tax purposes. This would be caused if different depreciation methods were used. For example, if the personal character was depreciated using an accelerated method for Regular Tax purposes, then the basis in that character when calculating gain or loss on sale would be different because the straight-line method had to be used for different Minimum Tax purposes.
Gain on the sale of investment character generally is capital gain, although a portion may be treated as ordinary income depending on the accelerated depreciation method was used. Capital gains alone are not an AMT item, but nonetheless they can consequence in AMT being paid. This is because the AMT exemption amount is phased out for taxpayers at certain income levels, so this additional income can have the consequence of reducing the exemption which in turn increases taxable income for purposes of the different Minimum Tax.