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Question:


What is a tax shelter?
-DawnGoal


Answer:


A tax shelter is an investment whose main purpose is not to achieve income or capital gains, or even necessarily to finance some economically productive activity, but to reduce tax liability. Tax shelters often use complex structures, such as limited partnerships, to take advantage of features in the U.S. Tax Code that allow investors to take large write-offs before they sell the investment and often before it produces any return. One of those features is the ability to deduct interest expenses, so it’s no coincidence that real estate is often the underlying asset. By mortgaging a property to the hilt, investors may be able to take huge interest deductions in relation to the amount of money they put down.

Another loophole often exploited is accelerated depreciation. When property such as manufacturing equipment or a commercial vehicle is put into service, it begins to lose value – nothing lasts forever, right? – so businesses can write off the cost over time. As an incentive to buy such items, the tax code allows them to take the write-offs in the first few years, even when the property is expected have a far longer useful life. A tax shelter might involve forming a partnership or corporation to invest in oil drilling equipment that would be leased out to an exploration company, with big depreciation deductions coming to the investors regardless of whether anything gushes up out of the earth.

Investors who have large incomes and live in high-tax states like New York, New Jersey or California could easily pay half of their marginal income in tax, so they have more to shelter. But even they have less need for these vehicles than they used to. Although tax rates have gone up in the last year, the highest rates are lower than before the tax code was overhauled in the 1980s. The depreciation rules are not as generous as they used to be, limiting the value of tax shelters that rely on them, and interest rates are far lower than they were a generation ago. Deductions allowed for contributions to 401(k) and other retirement plans are far more generous, too. All of those factors have diminished the usefulness of tax shelters over the years, and if Washington ever decides to revamp the tax code again, they could become all but obsolete.

-Conrad de Aenlle



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