Alternative Minimum Tax and passive activity rules


What is the Alternative Minimum Tax?

Under the Alternative Minimum Tax (Alt-Min), certain tax deductions, called tax preference items, are given limited effect. Depreciation is a tax preference item. The law was passed in 1969 in order to prevent a few wealthy individuals from escaping income taxes completely by virtue of their many deductions. It was pretty much a public relations ploy and was very popular with most Americans. The rules never changed to account for inflation, however.

The annual income of a wealthy individual in 1969 is a normal two-earner income in today's world. This means that average Americans are being caught in the Alt-Min trap. The New York Times estimates that by 2010, nearly thirty million Americans will have to pay additional taxes because of Alt-Min.

The Alt-Min calculations are complex. Fortunately, the IRS provides an electronic worksheet, called the "Alternative Minimum Tax Assistant for Individuals", at irs.gov. It lets you manipulate your numbers to see what happens. Do not worry - your identity is protected on this website. No information will be collected and matched against your actual tax returns later.You can also download Tax Topic 556, "Alternative Minimum Tax," for a better understanding of the rules.

What are the passive activity rules?

The IRS makes a distinction between certain types of income and expenses, especially those it considers a result of so-called passive activities. Passive activity expenses are deductible only from passive activity income. If expenses exceed income, then the losses cannot be used to offset other income, such as payroll income. Instead, the passive activity losses have to be carried forward and used in future tax years.

Rental activities are considered passive activities. For example, if you have US Dollars 35,000 of expenses associated with rental properties (because of depreciation deductions) and only US Dollars 12,000 of income, then you will pay no taxes on the US Dollars 12,000. However, you cannot use the leftover US Dollars 23,000 to reduce the taxable income from your day job. The good news is that there are three exceptions.

  1. Taxpayers may deduct up to US Dollars 12,500 in passive losses (up to US Dollars 25,000 for married couples) if they or their spouses actively participated in the real property activity.
  2. If the rental is a dwelling that the taxpayer uses for more than fourteen days per year or 10% of the days the dwelling is available for rental (whichever is greater), then it does not count as a passive activity. This would be your beach house, for example.
  3. The taxpayer is a real estate professional, which, for these purposes, means someone who performed more than 750 hours of services that year in real property trades or businesses in which he or she materially participated, and more than half the personal services the taxpayer performed in all trades or businesses was performed in real property trades or businesses.

That is a lot of technical IRS language. Converting it into plain English would take more pages than I can devote to the subject here. For more information, see IRS Publication 925, "Passive Activity and the At-Risk Rules," and Tax Topic 425, "Passive Activities - Losses and Credits," at the IRS website, irs.gov.

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Note: This article was sent to us by: Jeanette Dormer at 06262010

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