Depreciation expense and the proper treatment and timing of the deduction are the most common questions my office answers for new breeders. The $100,000 Section 179 expense election has been a “market maker,” in that buyers looking for depreciation write offs have been able to offset a significant amount of wage income or farm earning when purchasing breeding livestock. The larger and faster the tax write-off, the more incentive they have to invest in new assets, whether it be breeding livestock or equipment.

The $100,000 Section 179 expense limitation was set to expire in 2005. The 2004 Tax Act not only extended the time through 2007, but it also allows the deduction to be indexed for inflation. The amount for 2004 will actually be $102,000 and the projected amount for 2005 will be $105,000. Breeders who are looking to substantially build their herd through purchases over the next several years will be able to utilize large depreciation write-offs in each year if the purchases are managed properly.

Before relying on this deduction, speak to your tax professional. The first rule is not to place in service more than $400,000 (also to be indexed for inflation) of assets in any given year or the $100,000 deduction may be limited. A second rule, but equally important, is to make sure that you have enough earned income to offset the Section 179 expense. Earned income is wages, Schedule C earnings, or Schedule F earnings. Passive and retirement income is NOT allowed to be offset by Section 179 depreciation expense.
Passive income includes interest, dividends, capital gains, rental income, and any retirement distributions.

If you have chosen to form an LLC or Sub-Chapter S-Corporation, note that there must be enough income generated within the entity to absorb the Section 179 deduction. The Section 179 expense can only take the entity’s taxable income to zero, it cannot create a loss. Any excess amount is carried forward until such time as there is sufficient income to absorb the deduction. I don’t advocate immediately forming an LLC if you are looking for a large depreciation deduction up front. There have been new breeders who have formed an LLC and were anticipating being able to use the flow through loss against their wage income, not realizing that the expense first had to be allowed at the entity level before passing through to the personal return.

The 2004 Tax Act also made provisions for taxpayers to file amended returns during this extended election period. You have all heard of saying, “hindsight is 20/20.” Now we can amend returns significantly after the year has been closed and filed as long as it is within the three-year stature of limitations! Now changing one’s mind is a prerogative for everyone!

Alternative Minimum Tax

The next item affects many taxpayers, and if you haven’t heard of AMT be thankful. That means your accountant hasn’t had to explain to you something that you don’t want to hear. AMT stands for alternative minimum tax and there is actually nothing “minimum” about it. It is a second tax calculation that is based on what the IRS calls
“preference items.” If you have too many of what they deem to be preferences, you pay more than the original tax calculation. One of those preference items has been income averaged back to the three previous years’ income tax returns through farm income averaging.

Think of it this way. If you are a new breeder, and have losses recorded for the first two or three years of operation and then in the fourth year sell a package deal that generates a significant amount of income, you are stuck with picking up all of the income in the year of the sale. Farm income averaging allows taxpayers to average back the income and take advantage of any room left in lower tax brackets in previous years. This is a great tool, but in the past, the income carried back to previous years was subject to AMT tax, which often offset most of the tax savings generated by the averaging.

The 2004 Tax Act removed AMT tax on farm income averaging. I think this only makes sense. Agriculture is a business with extremely volatile earnings and loss years and I believe that taxpayers should be allowed to utilize the income tax brackets to the best of their ability, without being subject to AMT. No, the IRS did not call and ask me my opinion, but there it is anyway!

These two changes are positive to sellers and qualifying buyers will be able to count on the $100,000 depreciation deduction through 2007. Tax law is certainly working to keep the alpaca industry growing! Happy shopping!