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Alternative Minimum Tax and Depreciation

Todays Date: December 10, 2018

Surprisingly, one of every six individuals paying the Alternative Minimum Tax has depreciation as an AMT item. It may or may not individually be a large item to a particular taxpayer, but the good news is that it is easy to plan around, and this planning can be done any time up until the filing of the tax return. In other words, a taxpayer with this item still may have the opportunity to reduce his AMT for 2009.

There are numerous ways depreciation may show up in an individual taxpayer’s Form 1040. One is rental property the individual owns; another is business property if the business is being operated as a sole proprietorship. Other ways are if the business or rental property is in a “pass-through” entity. Examples of these include LLCs, partnerships, and S corporations, in which case the income and expenses, and any of the separate AMT items, are reported on the individual owners’ tax returns.

Here’s how depreciation works. Assume a business asset cost $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 over this period.

But, in an effort to encourage investment, Congress allows a 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, here 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

While the double declining balance method may be used for Regular Tax purposes, it is not allowed for purposes of the Alternative Minimum Tax. The most accelerated depreciation method that may 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 schedules, the AMT item 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 – ($300) AMT item (AMT income is lower than Regular Tax income)
Year 4 – ($500) AMT item “
Year 5 – ($500) AMT item “

Total – $0

The planning opportunity here simply is 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 item to report. Note that this election is available each year for property that is 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 election is made in the filing of that entity’s tax return.

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