Taxation and Regulatory Compliance

Tax Preference Items: What They Are & How They’re Calculated

Understand the dual role of tax preference items. Learn how these favorable deductions can trigger a parallel tax calculation and affect your tax liability.

A tax preference item refers to specific income, deductions, or exclusions that receive favorable treatment under the standard income tax system. These provisions are written into the tax code to encourage economic behaviors and investments considered beneficial to the economy, such as investing in public infrastructure or small businesses. By allowing taxpayers to exclude certain income or take specific deductions, the tax code provides a financial incentive for these activities.

These preferences allow individuals to reduce their regular taxable income, resulting in a lower tax bill under the standard calculation. They are not loopholes but are defined legal allowances based on the policy that the economic activity they encourage is of greater value than the tax revenue given up.

The Alternative Minimum Tax Connection

Tax preference items are directly linked to the Alternative Minimum Tax (AMT), a parallel system that operates alongside the regular income tax. The AMT’s purpose is to ensure that taxpayers with high economic income pay a minimum amount of tax, even if they use preferences to lower their liability. It was created in response to concerns that some high-income individuals were legally paying no federal income tax.

Tax preference items are a primary reason a taxpayer might become subject to the AMT. The AMT calculation begins with regular taxable income and then adds back certain deductions and income exclusions allowed under standard rules. These “add-backs,” which include tax preference items, create a broader definition of taxable income for the AMT.

While a taxpayer benefits from a preference item under the regular tax system, that same item can trigger AMT liability. The more a taxpayer’s regular tax is reduced by these preferences, the more likely their tax under the AMT system will be higher. If the tax calculated under AMT rules is greater than the regular tax liability, the taxpayer must pay the higher amount.

Common Tax Preference Items

Several income sources and deductions are classified as tax preference items, which must be added back to income when calculating the AMT. These preferences can significantly reduce a taxpayer’s regular tax liability, creating the potential for the AMT to apply. Many of these items are passed through to individuals from investments in partnerships, LLCs, or S corporations on a Schedule K-1.

  • Interest from specified private activity bonds. While interest from most municipal bonds is tax-exempt for regular tax, interest on private activity bonds is a preference item. These bonds are issued by governments to finance projects for private entities, like sports stadiums, so the interest must be included in the AMT calculation.
  • Exclusion of gain on the sale of qualified small business stock (QSBS). For regular tax, a taxpayer can exclude a substantial portion of the gain from selling QSBS if it was held for more than five years. For AMT purposes, however, a portion of that excluded gain must be added back to income.
  • Percentage depletion. Owners of mineral or natural resource properties can deduct a percentage of the property’s gross income, which can exceed the property’s cost basis. The amount by which this depletion deduction exceeds the property’s adjusted basis is a tax preference item for the AMT.
  • Intangible drilling costs (IDCs). Related to oil and gas properties, these are costs for drilling and preparing wells that have no salvage value. Producers can deduct these costs immediately for regular tax, but the “excess” amount of this deduction is a preference item for the AMT.

Calculating the Alternative Minimum Tax

The AMT calculation systematically reverses the benefits of certain deductions and preferences to arrive at a different, often higher, taxable income base. The process starts with the taxpayer’s regular taxable income from their Form 1040. To this amount, all tax preference items are added back. Other adjustments are also made, such as adding back deductions for state and local taxes and certain medical expenses, which are not allowed for AMT.

The result of adding back preferences and making these other adjustments is the Alternative Minimum Taxable Income (AMTI). From the AMTI, the taxpayer subtracts a specific AMT exemption amount. For 2025, the exemption is $88,100 for single filers and $137,300 for those married filing jointly, though these amounts phase out at higher income levels.

The remaining income is then subject to AMT tax rates, which are primarily 26% and 28%. The result of this calculation is the Tentative Minimum Tax. The taxpayer pays whichever is higher: the Tentative Minimum Tax or their regular tax liability.

Reporting on Tax Forms

Taxpayers who may be subject to the AMT must use Form 6251, Alternative Minimum Tax—Individuals, to calculate and report the tax. This form guides the taxpayer through the process of re-calculating their income under AMT rules.

Part I of Form 6251 is dedicated to Adjustments and Preferences, where the add-backs are formally entered. The form lists various items, and taxpayers must enter the amounts for any that apply to them. For example, there are specific lines for tax-exempt interest from private activity bonds and the exclusion on the sale of small business stock.

The form walks the user through the calculation, starting with regular taxable income and adding the adjustments and preferences to arrive at AMTI. Subsequent parts of the form apply the AMT exemption and tax rates to determine the final tentative minimum tax. Filing Form 6251 is required if the resulting tax is higher than the regular tax or if certain tax credits are claimed.

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