Points are additional interest charges which are usually paid when a loan is closed and which are generally imposed by the lender in lieu of a higher interest rate. Where points are paid as compensation for the use of borrowed money (and thus qualify as interest for tax purposes) rather than as payment for the lender's services, the points are substituted for a higher stated annual interest rate. As such, points are similar to a prepayment of interest and under the Act are generally to be treated as paid over the term of the loan. This rule also applies to charges similar to points, whether called a loan-processing fee or a premium charge (if such fee or charge is compensation for the use of borrowed money).

The Act permits points paid by a cash method taxpayer on an indebtedness incurred in connection with the purchase or improvement of (and secured by) his principal residence to be treated as paid in the taxable year of actual payment. A loan will not qualify under this exception, however, if the loan proceeds are used for purposes other than purchasing or improving the taxpayer's principal residence, or if loan proceeds secured by property other than his principal residence are used to purchase or improve his residence. The exception applies only to points on a home mortgage, and not to other interest costs on such a mortgage. However, in order to qualify under this exception, the charging of points must reflect an established business practice in the geographical area where the loan is made, and the deduction allowed under this exception may not exceed the number of points generally charged in the area for this type of transaction.

Effective dates

The rules in this provision apply generally to any prepayment of interest (including points) after December 31, 1975. However, a transition rule excepts interest paid before January 1, 1977 (even if the taxpayer's taxable year ends after that date) if there existed on September 16, 1975, and at all times thereafter, either (1) a binding written contract for a prepayment of interest by the taxpayer, or (2) a written loan commitment for a loan to the taxpayer and if the contract or loan commitment required the prepayment of this amount of interest. In either of these situations, however, if the interest is paid. on or after January 1, 1977, the payment will be subject to this provision.

Congress intends that no inference should be drawn concerning the deductibility of prepaid interest paid before the effective dates of the new rule. It is expected that deductions for such prepayments will be determined according to the criteria of prior law.

Revenue effect

It is estimated that this provision will result in an increase in budget. receipts of less than $5 million annually.

b. Limitation on the Deduction for Investment Interest (sec. 209 of the Act and sec. 163(d) of the Code)

Prior law

Section 163 of the Internal Revenue Code provides, in general, that a taxpayer who itemizes his deductions may deduct all interest paid or accrued within the taxable year on his indebtedness. A limitation

is imposed under section 163 (d) on interest on investment indebtedness. Under prior law the deduction for such interest was limited to $25,000 per year, plus the taxpayer's net investment income and his long-term capital gain, plus one-half of any interest in excess of these amounts. Any remaining amount could be carried over to future years.

Reasons for change

As indicated above, in connection with the discussion of problems which occur with tax shelters, there is a question as to the extent to which a taxpayer should be permitted to shelter or reduce tax on income from the taxpayer's professional or income-producing activities by incurring an unrelated deduction. The Congress felt that the limitation on the deductibility of investment interest should be strengthened, in order to reduce the possibility that this deduction could be used to shelter noninvestment types of income. It was also felt that this provision may have some economic benefits by encouraging taxpayers to focus on the economic viability of particular investments (rather than possible tax advantages resulting from the interest deduction) before borrowing funds in order to make those investments.

Explanation of provisions

Under the Act, interest on investment indebtedness is limited to $10,000 per year, plus the taxpayer's net investment income. No offset of investment interest in permitted against long-term capital gain. An additional deduction of up to $15,000 more per year is permitted for interest paid in connection with indebtedness incurred by the taxpayer to acquire the stock in a corporation, or a partnership interest, where the taxpayer, his spouse, and his children have (or acquired) at least 50 percent of the stock or capital interest in the enterprise. Interest deductions which are disallowed under these rules are subject to an unlimited carryover and may be deducted in future years (subject to the applicable limitation). Under the Act, no limitation is imposed on the deductability of personal interest or on interest on funds borrowed in connection with the taxpayer's trade or business.

As under prior law, investment income (against which investment interest may be deducted) means income from interest, dividends, rents, royalties, short-term capital gains arising from the disposition of investment assets, and any amount of gain treated as ordinary income pursuant to the depreciation recapture provisions (secs. 1245 and 1250 of the Code), but only if the income is not derived from the conduct of a trade or business.

As indicated above, interest on funds borrowed in connection with a trade or business is not affected by the limitation. In this connection, rental property is (as under prior law) generally considered an investment property subject to the limitation, rather than as property used in a trade or business, if the property is rented under a net lease arrangement. The determination of whether property is rented under a net lease arrangement is made separately for each year. For this purpose, a lease is considered to be a net lease for a taxable year either if the taxpayer's trade or business expenses with respect to the property which are deductible solely by reason of section 162 of the code are less than 15 percent of the rental income from the property, or if the taxpayer is guaranteed a specified return, or is guaranteed, in whole or in part, against loss of income.

In determining net investment income, the investment expenses

taken into account are real and personal property taxes, bad debts, depreciation, amortizable bond premiums, expenses for the production of income, and depletion, to the extent these expenses are directly connected with the production of investment income. For purposes of this determination, depreciation or depletion with respect to any property is taken into account on a straight-line or cost basis, respectively.

In the case of partnerships, the limitation on the deduction of interest is applied only at the partner level. In other words, each partner separately takes into account his share of the partnership's investment interest and other items of income and expense taken into account for purposes of the limitation. Similar treatment is provided in the case of subchapter S corporations. In this case, each shareholder of the corporation takes into account the investment interest of the corporation and the other items of income and expense which are taken into account for purposes of the limitation on a pro-rata basis in a manner consistent with the way in which the shareholders of the corporation take into account a net operating loss of the corporation.

Generally, these rules are applicable to taxable years beginning after December 31, 1975. However, under a transition rule, prior law (sec. 163 (d) before the amendments made under the Act) continues to apply in the case of interest on indebtedness which is attributable to a specific item of property, is for a specified term, and was either incurred before September 11, 1975, or is incurred after that date under a binding written contract or commitment in effect on that date and at all times thereafter (hereinafter referred to as "pre-1976 interest"). As under prior law, interest incurred before December 17, 1969 ("pre1970 interest") is not subject to a limitation.

Under the Act, carryovers are to retain their character. Thus, carryovers of pre-1976 interest will continue to be deductible under the limitation of prior law. Carryovers of post-1975 interest will be subject to the new rules adopted under the Act.

In a case where the taxpayer has interest which is attributable to more than one period (pre-1970, pre-1976, and post-1975), the taxpayer's net investment income is to be allocated between (or among) these periods. For example, assume a taxpayer has $30,000 of pre-1976 interest and $60,000 of post-1975 interest; also assume that the taxpayer has $45,000 of investment income. Under the Act, one-third of the investment income ($15,000) is to be allocated to the pre-1976 interest, which would be fully deductible (the $25,000 allowance, plus the $15,000 of net investment income-exceeds the $30,000 of pre-1976 interest, which is therefore fully deductible). Two-thirds of the net investment income ($30,000) is allocated to the post-1975 interest; this amount, added to the $10.000 allowance provided under the Act, would result in a total deduction of $40.000 for the post-1975 interest. The remaining amount, ($20,000) could be carried forward.

Effective date

Generally, these rules apply to taxable years beginning after December 31, 1975, subject to certain transition rules discussed above. Revenue effect

It is estimated that these provisions will result in a revenue gain of $100 million for fiscal year 1977, $110 million for fiscal year 1978, and $145 million for fiscal year 1981.

B. MINIMUM AND MAXIMUM TAX

1. Minimum Tax for Individuals (sec. 301 of the Act and secs. 5658 of the Code)

Prior law

Under prior law, individuals and corporations paid a minimum tax, in addition to their regular income tax, equal to 10 percent of their items of tax preference, reduced by a $30,000 exemption and their regular tax liability. The tax preferences subject to the minimum tax were: (1) the excluded one-half of capital gains; (2) the excess of percentage depletion over the basis of the property; (3) accelerated depreciation on real property; (4) the bargain element of stock options; (5) accelerated depreciation on personal property subject to a net lease; (6) the excess of amortization of on-the-job training and child care facilities over regular depreciation; (7) the excess of amortization of pollution control facilities over regular depreciation; (8) the excess of amortization of railroad rolling stock over regular depreciation; and (9) excess bad debt reserves of financial institutions. Regular taxes not used to offset preferences in the current year could be carried over for up to 7 additional years.

Reasons for change

The minimum tax was enacted in the Tax Reform Act of 1969 in order to make sure that at least some minimum tax was paid on tax preference items, especially in the case of high-income persons who were not paying their fair share of taxes. However, the previous minimum tax did not adequately accomplish these goals, so the Act contains a substantial revision of the minimum tax for individuals to achieve this objective.

Congress intended these changes to raise the effective tax rate on tax preference items, especially for high-income individuals who are paying little or no regular income tax.

Explanation of provision

The Act raises the minimum tax rate from 10 percent to 15 percent. The Act replaces the $30,000 exemption and deduction for regular taxes allowed under prior law with an exemption equal to the greater of $10,000 or one-half of regular tax liability. In addition, the Act repeals the carryover of regular taxes paid. These changes are intended to raise the effective rate of the minimum tax on tax preferences.

The Act also adds two new items of tax preference to the minimum tax base for individuals and modifies one existing preference item. The new preferences are excess itemized deductions and intangible drilling costs.

The new preference for excess itemized deductions equals the amount by which itemized deductions (other than medical and casualty deductions) exceed 60 percent of adjusted gross income. (Itemized deduc

tions in excess of 100 percent of adjusted gross income are not taken into account in this computation.) This preference is intended to.reduce the number of situations in which a person with a large adjusted gross income is able to avoid paying any income tax. Medical and casualty deductions are excluded from this preference item because they are limited to expenses that are beyond the control of the taxpayer.

The new preference for intangible drilling costs applies to those expenses in excess of the amount which could have been deducted had the intangibles been capitalized and either (1) deducted over the life of the well as cost depletion or (2) deducted ratably over 10 years; the taxpayer may choose whichever of these two methods of capitalization is most favorable. The calculation of the amount which could have been deducted under capitalization in a taxable year is to be made for those intangible drilling costs which were paid or incurred in the taxable year. This preference does not apply to taxpayers who elect to capitalize their intangible drilling costs.

The new preference does not apply to nonproductive wells. For this purpose, nonproductive wells are those which are plugged and abandoned without having produced oil and gas in commercial quantities for any substantial period of time. Thus, a well which has been plugged and abandoned may have produced some relatively small amount of oil and still be considered a non-productive well, depending on the amount of oil produced in relation to the costs of drilling.

In some cases it may not be possible to determine whether a well is in fact nonproductive until after the close of the taxable year in question. In these cases, no preference is included in the minimum tax base with respect to any wells which are subsequently determined to be nonproductive. Thus, if a well is proved to be nonproductive after the end of the taxable year but before the tax return for the year in question is filed, that well can be treated as nonproductive on that return. If a well is not determined to be nonproductive by the time the return for the year in question is filed, the intangible expenses with respect to that well are to be subject to the minimum tax. However, the taxpayer may later file an amended return and claim a credit or refund for the amount of any minimum tax paid with respect to that well if the well subsequently proves to be nonproductive.

The preference for accelerated depreciation on personal property is expanded in two ways. Under prior law, it applied only to net leases: the Act expands it to all leases. Also, the definition of accelerated depreciation is expanded to include the acceleration that results from the 20-percent variance under the Asset Depreciation Range (ADR) system. The preference for accelerated depreciation on personal property is not intended to apply to personal property which is leased as an incidental part of a real property lease. For example, the inclusion of a refrigerator in the lease of an unfurnished apartment is not to be treated as a lease of personal property.

There are certain cases in which a person derives no tax benefit from an item of tax preference because, for example, the item is disallowed as a deduction under other provisions of the Code or because the taxpayer has sufficient deductions relating to nonp" ference items to