What is 'Tax Exempt'

Tax exempt refers to income earnings or transactions that are free from tax at the federal, state or local level. When a taxpayer earns wages or sells an asset for a gain, that individual is creating a tax liability. While a tax deduction refers to an amount that reduces a tax liability, a tax-exempt item is excluded from any tax calculations.

BREAKING DOWN 'Tax Exempt'

A tax deduction is a deduction from gross income that is based on certain expenses incurred by a taxpayer, and deductions are subtracted from gross income to arrive at taxable income. Federal and state tax codes provide many types of tax deductions, such as an individual taxpayer’s deduction for home mortgage interest payments. Tax-exempt items, on the other hand, may be reported on the tax return for informational purposes, but the item is not part of any tax calculations.

Factoring in Tax-Exempt Interest

One common type of tax-exempt income is interest earned on municipal bonds, which are bonds issued by states and cities to raise funds for general operations or for a specific project. When a taxpayer earns interest income on municipal bonds issued in his state of residence, the income is exempt from both federal and state taxes. Taxpayers receive a form 1099-INT for any investment interest earned during the year, and tax-exempt interest is reported in box 8 of the form. Tax-exempt interest is reported for informational purposes only and is not included in the calculation of personal income taxes.

Examples of Capital Gain Tax Exemption

When a taxpayer buys an asset and subsequently sells the asset for a gain, the capital gain is a taxable event. Several type of capital gains are exempt from taxation. A taxpayer can offset capital gains with other capital losses for the tax year. For example, an investor with $10,000 in gains and $5,000 in losses pays tax on only $5,000 in capital gains, and a large amount of capital losses and can be carried forward to offset gains in future years. The tax code also allows taxpayers to exclude a portion of capital gains on a home sale from federal tax, up to a specific dollar amount; this rule was put in place to allow homeowners to keep more of their home sale gains to fund retirement.

How Alternative Minimum Tax Works

The alternative minimum tax (AMT) is a second tax calculation required on the individual tax return. AMT adds back certain tax-exempt items into the personal tax calculation. Municipal bond income, for example, is added to the AMT tax calculation. A taxpayer must include the AMT calculation with the original tax return and pay tax on the higher tax liability.

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