In our last article we talked about the Alternative Minimum Tax item resulting from depreciation of business or rental property. A direct corollary of that issue is the AMT item that results from any subsequent sale or other disposition of such property. Critical to minimizing a taxpayer’s AMT is an understanding of the relationship between these two items.

When property is disposed of, a taxpayer calculates the gain or loss based on the difference between the selling price and his tax basis. For something like a stock or a bond, tax basis is the amount originally paid for the investment – that is all that is needed. This same concept also applies to the sale of business or rental property, but with one important difference – depreciation. In the case of depreciable property, tax basis is the amount originally paid, but then reduced for any depreciation taken.

The tax basis of depreciable property changes every year. In the example in the last article, a $10,000 machine was depreciated by taking a $4,000 deduction in the first year, and a $2,400 deduction in the second year. At the end of year 2, therefore, the tax basis of this machine was $3,600 ($10,000 less the $6,400 of total depreciation taken).

What would happen if the machine were sold at this point? The same basic principle of computing the difference between selling price and tax basis applies. Assume, for example, a sales price of $5,000. In this case the taxpayer’s gain would be $1,400, and this amount would be included in taxable income. This is the Regular Tax treatment.

The AMT item arises at the time of sale of property because, in general, a taxpayer uses a different method of depreciation for purposes of the Alternative Minimum Tax than is used for Regular Tax purposes. To the extent the taxpayer has these AMT items from differences in depreciation in prior years, the tax basis of that property similarly is different for the AMT than it is for the Regular Tax. Therefore, gain or loss on a sale of the property also is different. Essentially, the AMT difference in computing the gain or loss is a reversal of the Regular Tax-AMT depreciation differences in the past.

Continuing with the same example, if after two years a taxpayer has been allowed $5,100 in depreciation deductions for the AMT (see the prior article), the machine’s AMT tax basis is $4,900. Assuming a sale for $5,000, taxable gain for AMT purposes would be $100.

This $1,300 difference in taxable gain (the $100 of AMT gain compared to the $1,400 of Regular Tax gain) is an AMT item in the year of sale. This is a favorable adjustment in computing the taxpayer’s Alternative Minimum Tax. It would be entered as a negative number on the Form 6251, making Alternative Minimum Taxable Income $1,300 less than Regular Tax taxable income.

One out of every 14 AMT payers has this item, so it is important that both the Alternative Minimum Tax basis and the Regular Tax basis of depreciable property are properly calculated. Incorrect calculations can have the effect of negating other AMT planning that a taxpayer may have accomplished, costing real tax dollars.

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.