Tax Preference Items - Detailed Definition
Tax Preference Items are certain types of income or deductions that are added back to an individual’s or corporation’s gross income when calculating the Alternative Minimum Tax (AMT). The AMT is designed to ensure that individuals and corporations who benefit from tax advantages pay at least a minimum amount of tax.
These preference items are adjusted to reflect economic income more accurately and include things like accelerated depreciation on real estate, pre-1987 instalments on pension plan contributions, and tax-exempt interest from private activity bonds.
Examples
- Depreciation on Real Estate: If accelerated depreciation on real estate exceeds what would be calculated using a 40-year straight-line method, the excess amount is considered a tax preference item.
- Private Activity Bond Interest: Interest received from private activity bonds (issued for non-governmental investments) is added to income.
- Incentive Stock Options (ISOs): When ISOs are exercised, the difference between the market price and exercise price is considered a tax preference item.
Frequently Asked Questions (FAQs)
Q1. What is the purpose of identifying tax preference items?
The main objective is to ensure Equity in the taxation system by subjecting businesses and individuals who receive significant tax breaks to pay a minimum amount of tax through the Alternative Minimum Tax (AMT).
Q2. Do tax preference items only apply to individuals?
No, they apply to both individuals and corporations, ensuring that both are equally accountable for a minimum amount of contribution to tax revenues.
Q3. Is depreciation always considered a tax preference item?
No, only certain types of accelerated depreciation which exceeds the limits set, such as that above what would be calculated using a 40-year straight-line method, are considered tax preference items.
Q4. Can AMT be applied every tax year?
AMT applicability varies by individual and organizational finances year-over-year, depending on incomes and deductions that constitute tax preferences that year.
- Alternative Minimum Tax (AMT): A parallel tax system designed to ensure that taxpayers with high incomes pay a minimum amount of tax, preventing the exclusive benefit from tax preferences.
- Gross Income: The total income earned from all sources before any deductions or exemptions.
- Straight-Line Depreciation: A method of depreciating an asset in equal amounts over its useful life.
Online Resources
- IRS - Alternative Minimum Tax (AMT)
- Investopedia - Alternative Minimum Tax (AMT)
- TurboTax - What are AMT Preference Items?
References
- IRS Publication 535 - Business Expenses.
- Tax Guide for Small Business - IRS Publication 334.
Suggested Books for Further Studies
- “Understanding Taxes: AMT and Tax Preference Items” by Janet Walker
- “Tax Deductions and Credits: Maximizing Your Benefits” by Robert S. Moskowitz
- “Federal Income Taxation” by Joseph Bankman, Daniel N. Shaviro, and Kirk J. Stark
Real Estate Basics: Tax Preference Items Fundamentals Quiz
### What are Tax Preference Items?
- [ ] Deductions only applicable to corporate entities.
- [x] Specific types of income or deductions added to gross income that affect AMT.
- [ ] Interest only applicable to residential properties.
- [ ] Any form of revenue that is exempt from normal tax rates.
> **Explanation:** Tax Preference Items are specific types of income or deduction adjustments that are added back to gross income for the purpose of calculating the Alternative Minimum Tax to ensure a fair minimum taxation.
### Which of the following is an example of a tax preference item?
- [ ] Rent income from a leased property.
- [x] Accelerated depreciation exceeding 40-year straight-line depreciation.
- [ ] Dividends from stock investments.
- [ ] Sale proceeds of a primary residence.
> **Explanation:** Accelerated depreciation on real estate, exceeding what would result from a 40-year straight-line depreciation method, is an example of a tax preference item.
### What is the purpose of the Alternative Minimum Tax (AMT)?
- [ ] To increase the minimum wage across the country.
- [x] To ensure that high-income earners pay a minimum level of tax.
- [ ] To provide tax credits to all taxpayers.
- [ ] To encourage repeat tax filings.
> **Explanation:** The AMT is designed to ensure high-income earners who benefit from various tax advantages still pay a baseline amount of taxes.
### Do tax preference items only apply to individual taxpayers?
- [ ] Yes, only individuals are subject to tax preference items.
- [ ] No, they apply only to non-profit organizations.
- [x] No, tax preference items apply to both individuals and corporations.
- [ ] Yes, tax preference items are solely for municipal bonds.
> **Explanation:** Tax preference items apply to both individuals and corporations, ensuring equitable tax contribution across varied entities.
### Can housing depreciation impact the Alternative Minimum Tax (AMT)?
- [x] Yes, if it exceeds the amount allowed under a 40-year straight-line basis.
- [ ] No, depreciation costs are excluded from AMT calculations.
- [ ] Only present depreciation, not past, affects AMT.
- [ ] No, housing appreciation affects AMT.
> **Explanation:** Depreciation on real estate that exceeds the limit calculated by a 40-year straight-line method can impact the AMT.
### Are Incentive Stock Options considered a tax preference item?
- [ ] Yes, always when unexercised.
- [x] Yes, when exercised and the market price exceeds the exercise price.
- [ ] No, ISOs cannot be considered tax preference items.
- [ ] Only when the market price is below the exercise price.
> **Explanation:** Incentive Stock Options (ISOs) are considered a tax preference item when exercised, and the market price exceeds the exercise price.
### Does AMT apply every tax year by default?
- [ ] Yes, to ensure every filer pays it.
- [ ] No, only specific businesses pay it quarterly.
- [x] No, it depends on the income and deductions for a particular tax year.
- [ ] Yes, it applies irrespective of deductions.
> **Explanation:** The applicability of AMT varies based on actual income and qualifying deductions each tax year.
### What method of depreciation reduces tax liability for businesses?
- [ ] Straight-line depreciation.
- [x] Accelerated depreciation, but it's limited by AMT calculations.
- [ ] Balloon payment depreciation.
- [ ] Historical depreciation method.
> **Explanation:** Accelerated depreciation reduces tax liability for businesses but can lead to adjustments under AMT calculations.
### What kind of bonds can result in a tax preference item due to their interest?
- [ ] Government municipal bonds.
- [ ] Bonds issued by neighborhood nonprofits.
- [x] Private activity bonds.
- [ ] Treasury savings bonds.
> **Explanation:** Interest earned from private activity bonds is treated as a tax preference item, affecting AMT calculations.
### Which of the following is primarily reviewed to compute the AMT?
- [ ] Annual mortgage on primary residence
- [x] Adjustments and preference items within the income
- [ ] Real estate property value
- [ ] Luxury tax on premium automobiles
> **Explanation:** Adjustments and tax preference items within an individual's or corporation's income are reviewed to compute the AMT.
