Surprisingly, one in six people who pay the alternative minimum tax has depreciation as an element of AMT. It may or may not individually be an important item for a particular taxpayer, but the good news is that planning is easy and this planning can be done at any time until the filing of the tax return. In other words, a taxpayer with this item may still have the opportunity to lower their AMT for 2009.
There are numerous ways that depreciation can show up on an individual taxpayer’s Form 1040. One is the rental property that the individual owns; another is commercial property if the business is operated as a sole proprietor. Other ways are if the business or rental property is in a “transfer” entity. Examples of these include LLCs, partnerships, and S corporations, in which case income and expenses, and any of the separate AMT items, are reported on individual owners’ tax returns.
This is how depreciation works. Assume that a business asset costs $ 10,000 and that the period for which it will be used (its “useful life”) is 5 years. Under the basic “straight line” depreciation method, the taxpayer would report an expense of $ 2,000 per year during 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 first few 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
While the double declining balance method can be used for regular tax purposes, it is not allowed for alternative minimum tax purposes. The fastest depreciation method that can be used to calculate a taxpayer’s AMT in this example, the so-called “150% declining balance” method, would result in deductions for depreciation 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
By matching these two schedules, the AMT element 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 is to simply 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. Please note that this choice is available each year for the property that is put into service during that year. However, also note that the choice of method is made at the entity level, so if the ownership is in an LLC, partnership, or S corporation, the choice is made at the filing of that entity’s tax return. .