One of every seven taxpayers subject to the Alternative Minimum Tax is paying it, at least in part, because of what is known in the tax law as a passive activity. A passive activity is the tax characterization of a certain type of investment, and it may be possible for a taxpayer to reduce his AMT by paying attention to the investments in his portfolio that are triggering this item.
In general, a passive activity is either: 1) a trade or business in which the taxpayer did not materially participate; or 2) an investment involving rental real estate. “Material participation” means active involvement in the operations of the business on a regular, continuous and substantial basis. A typical passive activity is an investment partnership in which the taxpayer is a passive investor, not involved in the day-to-day management.
The passive activity rules were enacted as a way to curtail the use of tax shelters, where individual investors had ownership interests in partnerships that were generating tax losses that the individuals reported in their tax returns. Before the passive activity rules, these investors were allowed to offset other income, like dividends, interest, and salaries and wages, with these losses.
Passive activity losses are very limited in how that may be used against other income for purposes of the Regular Tax. If they cannot be used in the year they are first generated, the losses are carried forward to a future year when they can be used against income generated from the passive activities. In many cases this is the year the taxpayer exits the activity.
For purposes of the Alternative Minimum Tax, these same limitations apply, but the difference is that there also may be AMT items included within the computation of the passive activity loss itself. One common example is depreciation, whether the activity is rental property or a trade or business. For purposes of computing the amount of AMT loss that may be used against AMT passive income, whether in the current year or to be carried forward to be used in a future year, AMT adjustments like depreciation must be taken into account.
As an example of how this works, assume a taxpayer is a partner in a partnership and the Schedule K-1 the taxpayer receives shows the following:
– a Regular Tax passive activity loss of $2,500
– a depreciation adjustment of $500 (less depreciation allowed for the AMT)
– an adjustment of $250 to the gain from sale of property (less gain for the AMT)
In this case the taxpayer’s passive activity loss for Alternative Minimum Tax purposes is $2,250. It is important for the taxpayer to keep records of this difference in order to be able to properly compute his Regular Tax and his AMT in the years the loss is utilized, particularly in view of the impact it could have on his overall AMT planning.