Real estate and AMT: Rental or investment properties

The alternative minimum tax is a very important consideration for taxpayers who own real estate, since almost every real estate tax rule is different for the AMT than for the regular tax. This article on real estate and the AMT addresses situations where the person holds the property as an investment, typically a rental property. The differences in tax treatment between regular tax and AMT can be significant.

interest expense

Interest paid on the mortgage taken out to purchase the property is fully deductible under both regular tax and alternative minimum tax. Unlike individual deductions, which provide a tax benefit for personal expenses, tax law generally permits any deductions that a taxpayer must make to obtain business income. Therefore, the restrictions discussed in the previous article on home mortgage rates do not apply.

However, if the rental property’s equity is being used as collateral for an additional loan – such as a second mortgage – the taxpayer must consider how the proceeds of that loan are used to determine the interest deduction. For example, if the proceeds are used for a car loan or to fund a child’s education, the interest is non-deductible self-interest. If the proceeds are used to improve the rental property, the interest is deductible.

Suggestion – It is best if taxpayers separate personal loans from business loans. Mixing the two creates recordkeeping challenges and can lead to disputes with the IRS.

property taxes

Property taxes paid on leased or investment property are fully eligible for both regular tax purposes and the alternative minimum tax.

Planning Idea – If you have the opportunity to pay your property tax bill either this year or next, pay it in a year when you have enough income from the property not to generate a rental loss. This strategy can help avoid triggering the passive loss of activity limitations described below.

Example – in Florida, property tax bills are mailed in October and are payable according to the following discount schedule: November – 4%, December – 3%, January – 2%, February – 1%. If you have a loss on property in 2010 but expect to generate income in 2011, don’t pay your bill in November or December – not getting this small rebate could help you get around the loss limitation rules.

depreciation

Depreciation is allowed for investment property. The part of the acquisition cost attributable to the land is not depreciable, but a depreciation deduction can be made for the building itself and the furniture, appliances, carpets, etc.

Real estate (this is the legal definition of house or other building) held for rental/investment is allowed to be depreciated over a useful life of 27.5 years using the ‘straight line’ method for regular tax purposes only. Thus, a property with $275,000 allocated to the building would be depreciated at a rate of $10,000 per year.

Personal property (this is the legal definition of things like furniture, appliances, carpets and the like) can be depreciated for regular tax purposes using an ‘accelerated’ method over a useful life of five years. An accelerated method allows for a larger depreciation deduction in the early years to account for obsolescence or depreciation that you see in new real estate (cars are a good example).

However, for AMT purposes, personal property may only be depreciated using a straight-line method. Thus, when using the accelerated procedure, an AMT item is generated in the early years.

Planning Idea – For personal property, consider choosing the linear method for regular tax purposes. While you forego a small tax benefit from the higher depreciation in the early years, it could mean avoiding paying the AMT.

Rules for active/passive investments and the “at-risk” rules

A taxpayer who is not “active” in the management of investment property is not allowed to use losses on rental property to offset other income such as salaries and wages, dividends, interest, capital gains, etc. Instead, those losses are deferred until the taxpayer either sells the property or generates passive income from that or other passive investment sources.

The risk rules similarly discourage the use of this type of loss, provided the taxpayer acquired the investment on borrowed money and is not personally liable for the debt.

planning idea

If these loss limitations apply, consider the planning ideas above to minimize the losses you incur each year. They’re not doing you any good anyway.

Sale of the property

Various AMT issues can arise when selling leased/investment property. One is that your gain or loss for AMT may be different than for regular tax purposes. This would be caused if different depreciation methods were used. For example, if the personal property was depreciated using an accelerated method for regular tax purposes, then the basis for that property in calculating the gain or loss on sale would be different since the straight-line method had to be used for alternative minimum tax purposes.

Gain on the sale of investment property is generally a capital gain, although some of it may be treated as ordinary income depending on which accelerated depreciation method was used. Capital gains in and of themselves are not an AMT item but may still result in AMT being paid. This is because the AMT exemption is being phased out for taxpayers with certain income levels, so this additional income can result in the exemption being reduced, which in turn increases taxable income for alternative minimum tax purposes.