Option Minimum Tax and Passive Activities

One of each seven taxpayers subject to the Option Minimum Tax is paying it, at the very least in component, due to what exactly is identified in the tax law as a passive activity. A passive activity will be the tax characterization of a particular type of investment, and it may be doable for a taxpayer to minimize 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 small business in which the taxpayer didn't materially participate; or
2) an investment involving rental real estate.

"Material participation" means active involvement inside the operations of the organization on a common, continuous and substantial basis. A typical passive activity is an investment partnership in which the taxpayer is really a passive investor, not involved in the day-to-day management.

The passive activity rules had been 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. Prior to 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 could be utilized against other income for purposes of the Regular Tax. If they cannot be utilized within the year they are initial generated, the losses are carried forward to a future year when they might be employed against income generated from the passive activities. In quite a few cases this will be the year the taxpayer exits the activity.

For purposes of the Option Minimum Tax, these very same limitations apply, but the difference is that there also may perhaps be AMT items included within the computation of the passive activity loss itself. One popular example is depreciation, regardless of whether the activity is rental property or a trade or organization. For purposes of computing the amount of AMT loss that may well be utilized against AMT passive income, no matter whether inside the existing year or to be carried forward to be utilized in a future year, AMT adjustments like depreciation need to be taken into account.

As an example of how this works, assume a taxpayer can be a partner in a partnership along with the Schedule K-1 the taxpayer receives shows the following:

- a Standard 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 Option Minimum Tax purposes is $2,250. It truly is critical for the taxpayer to maintain records of this difference so that you can have the ability to correctly compute his Normal Tax and his AMT inside the years the loss is utilized, especially in view of the impact it could have on his overall AMT planning.