Tax Preference Item: What it is, How it is Calculated

What Is a Tax Preference Item?

A tax preference item is a type of income, normally received tax-free, that may trigger the alternative minimum tax (AMT) for taxpayers. Tax preference items include interest on private activity municipal-bonds, qualifying exclusions for small business stock, and excess intangible drilling costs for oil and gas - if the amount of these items exceeds 40% of AMT income. Tax preference items are added to the amount of AMT income in the IRS' tax formula.

Understanding Tax Preference Items

Alternative minimum tax (AMT) is the least tax that an individual or corporation must pay after all eligible exclusions, credits, and deductions have been taken. AMT is a mandatory supplement tax alternative to the standard income tax. It uses many common itemized deductions and, therefore, impacts high-income earners mostly because it eliminates many of those deductions. A taxpayer that makes more than the AMT exemption amount and uses the deductions must calculate his taxes twice – one calculation for the regular income tax, and another for the AMT. Individuals that have an adjusted gross income higher than the exemption ($71,700 for single/head of households and $111,700 for married filing jointly, as of 2019) must calculate the AMT, and pay the higher of both taxes calculated.

Items that must be included when calculating the alternative minimum tax are called tax preference items. The tax preference item is income that subjects an individual to the AMT. It is treated differently for regular tax and AMT purposes. This income is excluded when calculating one's ordinary tax liability but is included when calculating one's liability for the alternative minimum tax.

Thus, a tax preference item would be tax-deductible under normal circumstances but is not for purposes of the alternative minimum tax. If the amount of tax preference items exceeds a certain percentage of the taxpayer's income, the taxpayer must add these items back to his or her taxable income to compute the amount of tax owed, thus, creating a higher tax bill. To calculate the AMT, then, calculate the taxable income the usual way and then add back preference items for minimum tax purposes. Tax preference items include:

• Deductions for accelerated depreciation/depletion
• Net income from oil and gas properties
• Excess intangible drilling costs
• Interest on special private activity bonds reduced by any deduction (not allowable in computing the regular tax) which would have been allowable if such interest were included in gross income
• Qualifying exclusion for small business stock
• Capital gains from exercise of stock options
• Investment tax credits

Like the AMT itself, tax preference items are designed to prevent high-income taxpayers from avoiding too much income tax through participating in certain activities. For example, investors who own private-activity bonds (PAB) issued after August 1986 must declare all income received from these bonds, minus investment expenses. This rule, thereby, prevents taxpayers from shielding all of their investment income in this type of bond issue.

Calculating AMT

To determine if they owe AMT, individuals can use tax software that automatically does the calculation, or they can fill out IRS Form 6251. This form takes medical expenses, home mortgage interest, and several other miscellaneous deductions into account to help tax filers determine if their deductions are past an overall limit set by the IRS.

The form also requests information on certain types of income such as on tax refunds, investment interest and interest from private activity bonds, as well as numbers corresponding with capital gains or losses related to the disposition of property. The IRS has specific formulas in place to determine which portion of these income and deductions the tax filers need to note on Form 6251, and it uses another set of formulas to determine how these numbers lead to AMTI.