What is a Tax Preference Item?

A tax preference item is income that subjects a taxpayer to alternative minimum tax (AMT). These items are treated differently for regular tax and AMT purposes.

How Does a Tax Preference Item Work?

According to U.S. tax code (26 USC section 57), there are several tax preference items, including:

  • Depletion
  • Intangible drilling costs
  • Net income from oil, gas, and geothermal properties
  • Interest on specified 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

Generally speaking, these items are tax-exempt, meaning that investors can deduct them from their taxable income and thus lower their tax bills. However, if an investor is subject to the AMT and the amount of these deductions exceeds a certain percentage of the taxpayer's income, the investor must add these items back to his or her taxable income to compute the amount of tax owed (thus creating a higher tax bill).

Why Does a Tax Preference Item Matter?

Tax preference items are part of a larger strategy to ensure that taxpayers do not abuse deductions and tax shelters in order to minimize taxes owed. This is the onus for the alternative minimum tax, and the government's designation of tax preference items is intended to help accomplish that strategy.

[InvestingAnswers Feature: The Alternative Minimum Tax Trap and How to Avoid It]

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Paul has been a respected figure in the financial markets for more than two decades. Prior to starting InvestingAnswers, Paul founded and managed one of the most influential investment research firms in America, with more than 3 million monthly readers.

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