Surprisingly, one in six individuals who pay the Alternative Minimum Tax have depreciation as an AMT item. It may or may not individually be a large item for a particular taxpayer, but the good news is that it is easy to plan for, and this planning can be done at any time up until the tax return is filed. In other words, a taxpayer with this item may still have the opportunity to reduce her AMT for 2009.
There are numerous ways that depreciation can appear on an individual taxpayer’s Form 1040. another is business ownership if the business is operated as a sole proprietorship. Other ways are if the commercial or rental property is in a “transfer” entity. Examples of these include LLCs, partnerships, and S corporations, in which case the income and expenses, and any separate AMT items, are reported on the individual owners’ tax returns.
This is how depreciation works. Assume that a business asset costs $10,000 and that the period over which it will be used (its “useful life”) is 5 years. Under the basic “straight-line” method of depreciation, the taxpayer would report an expense of $2,000 per year during this period.
But, in an effort to encourage investment, Congress allows the choice of other depreciation methods, all of which allow more of the expense to be deducted in the early years of the property’s life. For example, under something called the “double declining balance” method, this is how the cost would be recovered:
Year 1 – 40% or $4,000
Year 2 – 24% or $2,400
Year 3 – 14% or $1,400
Year 4 – 11% or $1,100
Year 5 – 11% or $1,100
Total – $10,000
Although the double declining balance method can be used for Regular Tax purposes, it is not permitted for Alternative Minimum Tax purposes. The most accelerated depreciation method that can be used for a taxpayer’s AMT calculation in this example, the so-called “150% declining balance” method, would result in depreciation deductions as follows:
Year 1 – 30% or $3,000
Year 2 – 21% or $2,100
Year 3 – 17% or $1,700
Year 4 – 16% or $1,600
Year 5 – 16% or $1,600
Total – $10,000
Matching these two calendars, the AMT heading in each of the 5 years is the difference between the two:
Year 1: $1,000 AMT item (AMT income is higher than regular tax income)
Year 2: $300 AMT item ”
Year 3 – AMT item ($300) (AMT income is less than regular tax income)
Year 4 – ($500) AMT Article ”
Year 5 – ($500) AMT Item “
Total – $0
The planning opportunity here is simply to choose a depreciation method that does not result in an AMT item. For Regular Tax purposes, a taxpayer may choose to use the 150% declining balance method (the AMT method) or the straight line method instead of the double declining balance method. By doing this, there will be no AMT element to report. Please note that this election is available each year for property placed in service during that year. Note also, however, that the choice of method is made at the entity level, so if the property is in an LLC, partnership, or S corporation, the choice is made at the filing of that tax return. entity.