investments, typically in limited partnerships, that can protect or defer (shelter) a portion of income from current taxes. Passive losses can be applied only to passive income. Usually, a significant amount of capital along with a very high amount of debt is necessary. Allowable deductions are generally permitted only to the amount at-risk. A tax shelter is desired by taxpayers in high tax brackets so they can take the losses from it to reduce their taxable income. Examples of tax shelters are real estate and oil and gas. Other permissible tax shelters are tax-exempt municipal obligations and single-premium life insurance policies. For failing to register a tax shelter there is a penalty of 1% of the aggregate amount invested, with no maximum. Failure to report a tax shelter identification number is $250. Penalties for shelters deemed abusive can be staggering. Tax shelters have been greatly restricted.
prior to October 23, 2004, defined by the IRS (in brief) as any investment with a greater than 2:1 ratio of deductions plus 350% of the credits to the amount invested or any investment whose purpose was primarily the avoidance or evasion of income taxes. Such investments were required to be registered with the IRS. These rules have since been repealed. After October 22, 2004, each material advisor must file an information return with the IRS that includes information on every reportable transaction required by the IRS, to be described at a later date.
method used by investors to legally avoid or reduce tax liabilities. Legal shelters include those using depreciation of assets like real estate or equipment, or depletionallowances for oil and gas exploration. limited partnerships traditionally offered investors limited liability and tax benefits including "flow through" operating losses which offset income from other sources. The tax reform act of 1986 dealt a severe blow to such tax shelters by ruling that passive losses could only offset passive income, lengthening depreciation schedules, and extending at risk rules to include real estate investments. Vehicles that allow tax-deferred capital growth, such as Individual Retirement Accounts (IRAs) and keogh plans (which also provide current tax deductions for qualified taxpayers), salary reduction plans, Simple IRAs, and life insurance, are also popular tax shelters as are tax-exempt municipal bond. The Roth IRA, created in the taxpayer relief act of 1997, allows tax free accumulation of earnings on assets held in the account for at least five years.
an investment that produces after-tax income that is greater than before-tax income. The investment may produce before-tax cash flow while generating losses to shield, from taxation, income from sources outside the investment.
Example: Dunn purchases an income-producing property that provides a tax shelter. In the first year, the property produces a Net Operating Income of $100,000. debt serviceis $80,000, of which $75,000 is interest. Dunn's before-tax cash flow is $20,000. First-year depreciation is $50,000, so that a tax loss is generated as shown in Table 53.
| TABLE 53 | ||
| TAX SHELTER | ||
| $100,000 | Net operating income | |
| - 75,000 | Interest deduction | |
| - 50,000 | Depreciation deduction | |
| ($25,000) | Taxable income (loss) |
Dunn not only pays no tax on the $20,000 cash flow but might be allowed to shelter $25,000 of income from other sources. The Tax Reform Act of 1986 places limits and restrictions on the deductibility of passive losses.
