Depreciation & Disposition of Property

Incorporate Your Small Business and Avoid the Alternative Minimum Tax

Saturday, July 30th, 2011 | Print This Post | Email This Post

The Alternative Minimum Tax applies both to corporations as well as to individuals. While many of the AMT rules are the same, there are some significant differences between the two. One of the more significant of these differences is a provision that totally exempts Small Business Corporations from the AMT. This can present real tax savings opportunities for individuals who are paying the Alternative Minimum Tax because of their business activities.

Small Business Corporation

A Small Business Corporation is an entity formed under state corporate law that has not made an election to be taxed as an “S” corporation. An S corporation does not pay tax itself; rather the income and losses – and AMT items – of the entity “pass through” to the corporation’s shareholders and are reported on the Forms 6251 attached to their individual Forms 1040. A “regular” corporation – including a Small Business Corporation – is separate from its owners, filing its own tax returns and paying its own taxes.

It should be noted that businesses that are formed and operated as sole proprietorships, partnerships or limited liability companies (LLCs) also pass through their income, losses and AMT items to the underlying owners just as S corporations do.

New business vs. existing business

A start-up business has total freedom to choose whatever form it wishes to operate in. Existing businesses currently operating in one of the pass-through forms may want to re-form themselves as Small Business Corporations to take advantage of this AMT benefit. While an S corporation may simply revoke its S election, for the other entities there are certain administrative costs associated with creating a new form of business that will need to be taken into consideration.

Total exemption from the AMT for a Small Business Corporation

In general the AMT applies to all corporations, just as it does to all individuals. However, Congress decided that smaller businesses operating in the corporate form should be totally exempt from the AMT. The test to qualify for this exemption is simple, and it is based on the gross receipts of the business.

If a small corporation has gross receipts of $5 million or less per year it qualifies as a Small Business Corporation, and, thus, it also qualifies for the AMT exemption. The actual test is the average of the entity’s gross receipts over a three-year period. Once a corporation initially qualifies as a Small Business Corporation under the $5 million test, in subsequent years it is allowed to have average gross receipts of up to $7.5 million while still retaining its qualification.

AMT items resulting from operating a business

This exemption from the Alternative Minimum Tax applies only to AMT items that result from operating a business. It does not apply, for example, to nonbusiness AMT items such as the adjustments needed for an individual’s itemized deductions like state and local taxes, home mortgage interest, medical and dental, etc., as well as things like incentive stock options.

The following are the AMT items associated with operating a business:

- depreciation, and corresponding adjustments on disposition of business property

- net operating losses

- depletion, intangible drilling costs and mining costs

- R&D expenses

- long-term contracts

- circulation costs

Other tax issues to be considered

There are a number of non-AMT tax benefits resulting from operating a business in a pass-through entity that also need to be taken into consideration when evaluating the Small Business Corporation benefit. For example, if a pass-through business has start-up losses, these losses may be deductible on the business owner’s personal tax return. For a regular corporation, such losses are accumulated and may be used as a deduction only against future income of the corporation.

If the business is profitable, there is a possibility that the profits from a regular corporation effectively could be taxed twice unless proper planning is done. With the corporation itself paying taxes on its income (after deducting any prior year losses), if it pays a dividend to its shareholders those profits would be taxed twice. This problem can be avoided if the business owners are paid salaries, which are deductible by the corporation, thus avoiding this double tax issue.

Planning to take advantage of this AMT exemption

The key for any taxpayer considering taking advantage of this total exemption from the Alternative Minimum Tax is to start by looking at how much AMT is being paid as a result of the above-listed business AMT items. Only if the total is material enough to offset the costs of changing the form of business, and only if the other tax issues mentioned above do not present negatives, should incorporation be considered.

Conclusion

As has been discussed in previous articles, each AMT item presents its own individual planning opportunities. For the items that result from operating a business, a taxpayer needs to go through each and every one of them to consider the effects of the choices and tax elections he has. As an alternative to this by-the-ones approach, having the business operating in a qualifying Small Business Corporation completely eliminates the need to do this, and might even result in totally avoiding the Alternative Minimum Tax!

Posted in AMT Planning in General, Depreciation & Disposition of Property, Self Employed, Type of Taxpayer | No Comments »

Real Estate and the AMT: Property Used in the Taxpayer’s Trade or Business

Sunday, October 10th, 2010 | Print This Post | Email This Post

The Alternative Minimum Tax is a very important consideration when real estate is involved because just about every tax rule applying to real estate is different for the AMT than it is for the Regular Tax. This last part of our four-part series will talk about real estate used in a taxpayer’s trade or business. This is a big investment for most small businesses, and the differences in tax treatment between the Regular Tax and the AMT can be significant.

For this article we are talking about businesses held in the form of a sole proprietorship, an S corporation, an LLC or a partnership. All of the Regular Tax and AMT issues discussed here show up on the individual owner(s) Form 1040 because every one of these types of businesses is treated as a “pass-through” entity for tax purposes.

Following the order of the issues described in the earlier parts of this series, here is a look at them as they apply to trade or business property.

Interest expense

Interest paid on a mortgage taken out to acquire business property is fully deductible, both for the Regular Tax and the Alternative Minimum Tax. Similar to the last article on rental/investment property, the limitations discussed in the first article on home mortgage interest simply not apply.

If the equity in the business property is used as security for an additional loan – a second mortgage, for example – then the taxpayer must look to the use of the proceeds of that loan. If the proceeds are used for a car loan or to finance a child’s education or for any other purpose, then the interest is nondeductible personal interest. So long as the proceeds are used in the business, the interest is fully deductible.

Property taxes

Property taxes paid on trade or business property are allowed in full both for Regular Tax purposes as well as for the Alternative Minimum Tax.

Depreciation

Depreciation is allowed for property used in a trade or business. The portion of the cost allocable to land is not depreciable, but for the building itself and the furniture & equipment a depreciation deduction may be taken.

Real property (the legal definition of the building) used in a trade or business may only be depreciated for Regular Tax purposes under the “straight line” method over a useful life of 39 years. Thus, a property with $390,000 allocated to the building would be depreciated at the rate of $10,000 per year.

Personal property (this is the legal definition of things such as machinery and equipment, furniture and fixtures, and computer equipment) may be depreciated for Regular Tax purposes under an “accelerated” method over a useful life of five or seven years. An accelerated method allows a larger depreciation deduction in the early years, in recognition of the obsolescence factor in new property (computers are a good example).

For purposes of the AMT, however, personal property may only be depreciated by using a straight-line method. Thus, an AMT item will be generated in the early years if the accelerated method is used.

Planning idea – consider electing to use the straight-line method of depreciation for Regular Tax purposes. While giving up a little tax benefit from the greater depreciation in the early years, it could mean avoiding paying the AMT.

Active/passive investment rules and the “at-risk” rules

The active/passive investment rules generally do not apply to a small business, because the business owner almost always is heavily involved in the day-to-day operations of the enterprise, and, thus, by definition is active. These rules would apply, however, to a financing partner or a silent partner who is not so involved. As a reminder, these rules as well as the at-risk rules would apply only in the years the business had losses.

Sale of the property

Several different AMT issues can arise on the sale of business property. These are essentially the same issues as those discussed in the last article, on Rental/Investment Property, with perhaps a few minor differences.

One AMT issue is that the taxpayer’s gain or loss will be different for the AMT than it is for Regular Tax purposes if the business personal property was depreciated using an accelerated method for Regular Tax purposes. Because the straight-line method had to be used for Alternative Minimum Tax purposes, the gain or loss will be different and the taxpayer will have an AMT item to report on the Form 6251.

Gains on the sale of business property generally are capital gains, although a portion will be treated as ordinary income if the accelerated depreciation method was used. Capital gains in and of themselves are not an AMT item, but they definitely can result in AMT being paid. This is because the AMT exemption – that keeps many taxpayers out of the Alternative Minimum Tax – is phased out for taxpayers above certain income levels. Additional income, even capital gains, can have the result of reducing the exemption which in turn increases taxable income for AMT purposes.

This issue is discussed in an article posted on amtblog.com on December 13, 2009. This article also can be found by searching for “alternative minimum tax planning – investments – capital gains.”

This is the final of four articles on Real Estate and the AMT. A new series of articles will begin soon, focusing on different types of taxpayers and the things to watch out for, along with associated planning opportunities, for each of these types. Stay tuned!

Posted in AMT Planning in General, Capital gains & Dividends, Depreciation & Disposition of Property, Investment Interest Expense, State Income & Other Taxes | No Comments »

Real Estate and the AMT: Rental or Investment Property

Wednesday, October 6th, 2010 | Print This Post | Email This Post

The Alternative Minimum Tax is a very important consideration for taxpayers who own real estate because just about every tax rule applying to real estate is different for the AMT than it is for the Regular Tax. This third part of our four-part series on Real Estate and the AMT will address those situations where the individual holds the real estate as an investment, typically as rental property. The differences in tax treatment between the Regular Tax and the AMT can be significant.

Following the order of the issues described in the earlier articles in this series, here is a look at them as they apply to rental/investment property.

Interest expense

Interest paid on the mortgage taken out to acquire the property is fully deductible, both for the Regular Tax and the Alternative Minimum Tax. Unlike itemized deductions that allow a tax benefit for what amounts to personal expenses, the tax law generally allows all deductions a taxpayer has to make in the pursuit of business income. Thus, the limitations discussed in the previous article on home mortgage interest do not apply.

If, however, the equity in the rental property is used as security for an additional loan – a second mortgage, for example – then the taxpayer must look to how the proceeds of that loan are used to determine interest deductibility. If the proceeds are used for a car loan or to finance a child’s education, for example. then the interest is nondeductible personal interest. If the proceeds are used to improve the rental property, the interest is deductible.

Suggestion – it is best that taxpayers keep personal borrowings separate from business borrowings. Mixing the two creates recordkeeping challenges and can result in disputes with the IRS.

Property taxes

Property taxes paid on rental or investment property are allowed in full both for Regular Tax purposes as well as for the Alternative Minimum Tax.

Planning idea – if you have an opportunity to pay your property tax bill either this year or next, pay it in a year when you have enough income from the property so as not to generate a rental loss. This strategy can help avoid triggering the passive activity loss limitations described below.

Example – in Florida property tax bills are mailed in October, and are payable under the following discount schedule: November – 4%, December – 3%, January – 2%, February – 1%. If you have a loss from the property in 2010 but expect to generate income in 2011, do not pay your bill in November or December – forgoing that small discount could help you avoid the loss-limitation rules.

Depreciation

Depreciation is allowed for property held for investment. The portion of the cost allocable to land is not depreciable, but for the building itself and the furniture, appliances, carpeting, etc. a depreciation deduction may be taken.

Real property (this is the legal definition of the house or other building) held for rental/investment may only be depreciated for Regular Tax purposes under the “straight-line” method, over a useful life of 27.5 years. Thus, a property with $275,000 allocated to the building would be depreciated at the rate of $10,000 per year.

Personal property (this is the legal definition of things such as furniture, appliances, carpeting and the like) may be depreciated for Regular Tax purposes under an “accelerated” method over a useful life of five years. An accelerated method allows a larger depreciation deduction in the early years, in recognition of an obsolescence or decline-in-value factor that you see in new property (cars are a good example).

For purposes of the AMT, however, personal property may be depreciated only by using a straight-line method. Thus, an AMT item will be generated in the early years if the accelerated method is used.

Planning idea – for personal property consider electing the straight-line method for Regular Tax purposes. While giving up a little tax benefit from the greater depreciation in the early years, it could mean avoiding paying the AMT.

Active/passive investment rules and the “at-risk” rules

A taxpayer who is not “active” in managing investment property may not use losses from rental property to offset other income such as salaries and wages, dividends, interest, capital gains, etc. Instead, these losses are deferred until the taxpayer either sells the property or generates passive income from this or other passive investment sources.

The at-risk rules similarly deny using these types of losses to the extent the taxpayer has acquired the investment with borrowed money and does not have personal liability on the debt.

Planning idea

If these loss limitations apply, consider the planning ideas mentioned above to minimize the losses being generated each year. They are not doing you any good anyway.

Sale of the property

Several different AMT issues can arise on the sale of rental/investment property. One is that your gain or loss may be different for the AMT than it is for Regular Tax purposes. This would be caused if different depreciation methods were used. For example, if the personal property was depreciated using an accelerated method for Regular Tax purposes, then the basis in that property when calculating gain or loss on sale would be different because the straight-line method had to be used for Alternative Minimum Tax purposes.

Gain on the sale of investment property generally is capital gain, although a portion may be treated as ordinary income depending on the accelerated depreciation method was used. Capital gains in and of themselves are not an AMT item, but nonetheless they can result in AMT being paid. This is because the AMT exemption amount is phased out for taxpayers at certain income levels, so this additional income can have the result of reducing the exemption which in turn increases taxable income for purposes of the Alternative Minimum Tax.

This issue is discussed in some detail in an article posted on amtblog.com on December 13, 2009. This article also can be found by doing an internet search for “alternative minimum tax planning – investments – capital gains.”

Next in this series on Real Estate and the AMT – property used in a taxpayer’s trade or business.

Posted in AMT Planning in General, Capital gains & Dividends, Depreciation & Disposition of Property, Investment Interest Expense, State Income & Other Taxes | No Comments »

Real Estate and the AMT: Home Ownership

Tuesday, September 21st, 2010 | Print This Post | Email This Post

The Alternative Minimum Tax is a very important consideration for taxpayers who own real estate because just about every tax rule applying to real estate is different for the AMT than it is for the Regular Tax. This second part of our four-part series on Real Estate and the AMT will address the most common form of real estate ownership – the taxpayer’s personal residence. Typically this is a taxpayer’s largest purchase, and the differences in tax treatment between the Regular Tax and the AMT can be significant.

Following the order of the issues described in our previous overview article, here is a look at how they apply to a personal residence:

Interest expense

Interest paid on a loan secured by a taxpayer’s home, referred to in the tax law as “qualified residence interest,” is deductible for purposes of the Regular Tax, subject to a few limitations. Interest on home acquisition debt is deductible in full to the extent the mortgage does not exceed $1 million, as is interest on home equity debt to the extent the debt does not exceed $100,000. Home equity debt, typically a second mortgage or a home equity line of credit, can be used for any purpose – a car loan or a child’s education are examples.

Under the AMT, a taxpayer is allow a full deduction for home acquisition debt. For home equity debt, however, it is AMT-deductible only if it is used to improve the residence, i.e., if it used for other purposes, such as the car loan or student loan mentioned above, it is not deductible for the AMT.

Planning idea – look to alternative means of financing instead of home equity debt when financing automobile purchases, college tuition, or other personal purposes. A special-offer automobile loan at 1.9%, for example, certainly would be less expensive financing than a home equity loan for an AMT payer.

Property taxes

Property taxes are allowed in full for Regular Tax purposes, but, along with all other state and local taxes, are not allowed at all as a deduction for the Alternative Minimum Tax.

Planning idea – if you have an opportunity to pay your property tax bill either this year or next, pay it in a year that you are not in the AMT. Depending on levels of income, itemized deductions and other factors, taxpayers may find themselves in the AMT one year but not the next.

Example – in Florida, property tax bills are mailed in October, and are payable under the following discount schedule: November – 4%, December – 3%, January – 2%, February – 1%. If you are in the AMT in 2010 but expect not to be in the AMT again in 2011, do not pay your bill in November or December - forgoing that small discount could save a taxpayer up to 39.6% of the amount of the property taxes on his Federal income tax bill next year.

Depreciation

Depreciation does not apply to a personal residence, except perhaps for a taxpayer claiming a portion of his residence as a “home office” or other business use. This topic will be discussed in some detail under the topics of rental/investment property and business property in the next two articles in this series.

Active/passive investment rules and the “at-risk” rules

Similar to Depreciation, these rules will be discussed in the next articles in this series; they do not apply to property held as a personal residence.

Sale of the property

A sale of a personal residence is not taxable to the extent the gain does not exceed $500,000, for a married couple filing jointly, or $250,000 for a single taxpayer. Any gains over these amounts are taxable, as long-term capital gains. Capital gains in and of themselves are not an AMT item, but they nonetheless can result in AMT being paid. This is because the AMT exemption amount is phased out for taxpayers at certain income levels, so this additional income can have the result of reducing the exemption which, in turn, increases taxable income for purposes of the Alternative Minimum Tax.

Next in this series on Real Estate and the AMT – property owned as rental/investment property.

Posted in AMT Planning in General, Capital gains & Dividends, Depreciation & Disposition of Property, Home Mortgage Interest, State Income & Other Taxes | No Comments »

Real Estate and the AMT: Overview

Tuesday, September 14th, 2010 | Print This Post | Email This Post

The Alternative Minimum Tax is a very important consideration for taxpayers who own real estate, because many of the rules that apply to real estate are different for the AMT than they are for the Regular Tax. This article is the first of a four-part series on Real Estate and the AMT. We’ll start with an overview of the differences in the rules, and then will drill down into the details in the three different situations taxpayers find themselves when they own real estate: 1) the taxpayer’s residence; 2) a rental/investment property; or 3) property used in the taxpayer’s trade or business. These articles will be updated periodically to reflect future changes in the tax law that affect the Regular Tax and AMT treatment of real estate.

Here are the things we will be looking at:

Interest expense

Except for anyone who travels in the Buffet/Gates social circles, every purchase of real estate will be financed. Financing, in turn, means that interest will be paid. In general, the tax law allows a deduction for this interest for Regular Tax purposes, although a number of different limitations can apply. These limitations vary, depending on whether the property is a residence, or is rental/investment or business property. The separate AMT limitations that apply to real estate also vary among these categories.

Property taxes

Property ownership brings with it the obligation to pay property taxes. In general, for Regular Tax purposes real estate taxes are deductible regardless of the reason for holding the property. This is not the case for Alternative Minimum Tax payers, however, for whom the deduction may be totally disallowed in some situations, yet allowed in others, depending on which of the three classifications applies.

Depreciation

Depreciation is a deduction that allows a taxpayer to recover the cost of an investment in property, depending again on the taxpayer’s purpose for holding the property. If depreciation deductions are allowable, the AMT has a set of rules different from the ones that apply for purposes of the Regular Tax.

Active/passive investment rules and the “at-risk” rules

In some cases the tax law’s active vs. passive investment rules, and/or the at-risk rules, will apply to individuals owning real estate. These are overarching rules that supersede the other individual tax law limitations. Even if they do apply, however, an AMT payer still must keep track of the separate AMT calculations required by the other limitations.

Sale of the property

Very few taxpayers hold on to property for life; at some point in the future it can be expected that the property will be sold. A number of special Regular Tax rules apply to the sale of real estate, and, in most cases, an AMT payer will have a different set of calculations to make.

Conclusion

Real estate is one of the biggest purchases most taxpayers make, and it is likely there will be a number of real estate purchases and sales throughout the taxpayer’s lifetime. The Regular Tax rules are complicated enough, but additional wrinkles exist in the calculations for Alternative Minimum Tax payers. With a little knowledge, however, these complications and wrinkles can present some real tax planning opportunities for AMT payers.

The next article in this series will address the specific tax issues for real estate owned as a personal residence – certainly the most common form of property ownership.

Posted in AMT Planning in General, Capital gains & Dividends, Depreciation & Disposition of Property, Home Mortgage Interest, State Income & Other Taxes | No Comments »

Top 10 Traps Set by the AMT

Saturday, April 10th, 2010 | Print This Post | Email This Post

Of the nearly 30 different items that can cause taxpayers to fall into the AMT, a few are much more common than others. Here is a quick look at the “top ten” list of those that snare the most Alternative Minimum Taxpayers.

# 1 – Personal exemptions

For the Regular Tax, every taxpayer is entitled to a personal exemption deduction for himself, and his spouse and/or other dependents. Since the AMT denies any deduction for personal exemptions, this is the single item affecting almost every individual paying the Alternative Minimum Tax.

# 2 – State and local tax deduction

This item, which consists of property taxes, state and local income taxes, and sales taxes, is only slightly behind personal exemptions in terms of the number of AMT payers affected. The reasons for this are the relatively heavy burden of state and local taxes as well as the fact that the AMT disallows every dollar of this deduction.

# 3 -Capital gains

This is not specifically listed as an AMT item, but the impact of capital gains on an individual’s Alternative Minimum Tax can be significant. At levels of taxable income where most AMT payers find themselves, an additional $100 of capital gains could add up to $7 of AMT being paid on top of the $15 imposed by the Regular Tax capital gains bracket.

# 4 – Miscellaneous Itemized Deductions

A taxpayer’s employee business or investment-related expenses may be deductible under the Regular Tax, but they are not for the AMT. This affects nearly a third of all AMT payers.

# 5 – Depreciation

Business owners and investors with rental property are allowed depreciation deductions for the property used in these activities. The AMT disallows a portion of the depreciation deduction that otherwise may be taken.

# 6 – Passive activity losses

Many investment activities are considered “passive” for tax purposes. An example is a taxpayer who acquires an interest in an investment partnership. As such, losses from these investments are limited in how they may be deducted for purposes of the Regular Tax. The AMT imposes even further limitations on the use of these losses.

# 7 – Private activity bond interest

An individual investing in tax-exempt municipal bonds may receive an unpleasant surprise when he discovers that Alternative Minimum Tax has to be paid on the interest income from a certain type of municipal bond – the so-called private activity bond. While there may be an increase in before-tax yield from this type of bond, the after-AMT results can be very disappointing.

# 8 – Standard deduction

A taxpayer is allowed no standard deduction in computing the AMT. A valuable planning idea here could mean that an AMT taxpayer might be better off not claiming the standard deduction at all.

# 9 – Medical and dental expenses

For purposes of the Regular Tax, individuals are allowed a deduction for medical and dental expenses, to the extent these expenses exceed 7.5% of Adjusted Gross Income. The AMT limits this deduction even further by instead imposing an excess-of-10% requirement.

#10 – Limitations on investment losses

In addition to the limitation on the use of passive activity losses as discussed above, there are other investment activities, not falling under the passive rules, the losses from which still will be limited for purposes of the Regular Tax. Again, the AMT places even further limitations on the use of these losses.

Conclusion

In addition to this top ten list, there are nearly 20 other individual items waiting to trip up the AMT payer. The individual items that catch any particular taxpayer are shown on that individual’s Form 6251 that is attached to his tax return. It is important to note, however, that planning opportunities exist that can lessen the impact of each and every one of these. Check these out at AMTIndividual.com.

Posted in Capital gains & Dividends, Depreciation & Disposition of Property, K-1 / All other AMT Items, Medical And Dental, Misc Deductions 2-percent Floor, Personal Exemptions, Private Activity Bonds, Standard Deduction, State Income & Other Taxes | No Comments »

Disposition of Business or Rental Property

Sunday, January 24th, 2010 | Print This Post | Email This Post

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.

Posted in Depreciation & Disposition of Property | No Comments »

Depreciation

Wednesday, January 20th, 2010 | Print This Post | Email This Post

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.

Posted in Depreciation & Disposition of Property | No Comments »