Tax Shelters

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A tax shelter is an investment that usually requires substantial contributions with a degree of risk. It often involves current losses to produce future gains. An investment in low income property that provides depreciation benefits is one example of a legitimate tax shelter. Generally, the amount of your deductions or losses from most activities is limited to the amount that you have at risk. You are considered at risk in an activity for the following amounts:
  1. The amount of cash you invested in the activity,
  2. The adjusted basis of other property you contributed to the activity; and
  3. The amount you borrowed to invest in the activity, to the extent that you are personally liable on the loan or have pledged property not used in the activity as security.
For more information on the at-risk rules, refer to Publication 925, Passive Activity and At-Risk Rules.

Note - -Tax shelter trade or business activity losses or credits are often considered passive activity losses or credits. Such losses or credits may only be used to offset income from other passive activities. They cannot be deducted against other income such as wages, salaries, professional fees, or portfolio income such as interest and dividends. Allowable losses or credits are computed on Form 8582 (PDF), Passive Activity Loss Limitations.

The excess passive losses and credits generated from passive activity tax shelters can be carried forward until you can use them or until you dispose of your investment in the tax shelter.

For more information on passive income and losses, refer to Passive Activities - Losses and Credits, Passive Activities — Losses and Credits or to Publication 925.

Abusive tax shelters exist solely to reduce taxes unrealistically. Abusive tax shelters are often marketed by promising a larger write-off than the amount invested. These schemes involve transactions with little or no economic foundation. Generally, one invests money to make money. A legitimate tax shelter exists to reduce taxes fairly and also produce income. As with any investment, a real tax shelter involves risks, while an abusive tax shelter involves little risk, despite outward appearances.

A series of tax laws has been designed to halt abusive tax shelters. These include requiring organizers of tax shelters to register them using Form 8264 (PDF), Application for Registration of a Tax Shelter, requiring material advisors to maintain a list of investors, requiring investors to report the tax shelter registration number on their tax return using Form 8271 (PDF), Investor Reporting of Tax Shelter Registration Number, and requiring investors to disclose the tax shelter on their tax return using Form 8886, Reportable Transaction Disclosure Statement.

Investors in abusive tax shelters whose returns are examined may be required to pay more tax, plus penalties and interest. Also, promoters of abusive tax shelters may be liable for significant penalties.

There are several legitimate investments you can make that will defer income until a later date, such as Individual Retirement Arrangements, retirement plans for self-employed individuals, and deferred annuities. These are not considered tax shelters because they usually do not involve tax losses. For more information concerning tax shelters, including issues to consider before investing, refer to Publication 550, Investment Income and Expenses.


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