What Is a Tax Shelter?Although it sounds like a specific place, a tax shelter is any investment strategy that enables you to legally decrease or avoid taxation. Actual tax shelter investments sometimes require a large investment with a degree of risk. The goal of many shelters is to create offsetting losses to other taxable income.
In order to take advantage of tax sheltering, you will need to be able to differentiate between two types of taxable income. Passive activity income is derived from a trade or business activity in which you didn't "materially participate" during the tax year. You are deemed to have "materially participated" by qualifying under one of seven IRS tests, each of which requires actual, substantial involvement in the business activity (for example, you spent at least 100 hours during the year in the activity, and nobody else spent any more time than you did.) Generally, you can only deduct passive activity losses from passive activity income.
A tax credit is a dollar-for-dollar reduction on the tax you owe.In most common situations, income from real estate rental is an example of passive income. There is a special break, however, allowing a passive loss from rental real estate to be deducted from non-passive income, such as wages. This passive loss deduction is limited to $25,000, but is reduced by 50 percent of the amount of the taxpayer's adjusted gross income that exceeds $100,000.
Active income, on the other hand, is income from wages, tips, salaries, commissions, and a trade or business in which you materially participate.
So, what other methods can you use to legally reduce taxes? Here are some of the most common:
- Lower your current taxable income. Placing your money in certain investments is one way to lower your taxable income.
- Lower the tax rate of certain income. For example, hold onto an investment long enough to be taxed at long-term rather than short-term capital gains rates.
- Increase your itemized deductions. Sometimes, you can combine deductions in one year to gain a higher benefit.
- Defer income to years when you expect to be in a lower tax bracket.
Another way to reduce the amount of tax you pay is to receive a tax credit, usually by making an investment or purchase the law wishes to encourage—buying a hybrid car, for example. A tax credit is a dollar-for-dollar reduction on the tax you owe. For example, a tax credit of $1,000 reduces the amount of tax you owe by $1,000. This is not the same as a tax deduction, which simply reduces taxable income. The value of the deduction, therefore, depends on your tax bracket. In a 28 percent tax bracket, a $1,000 deduction reduces your taxes by only $280. Dollar for dollar, a tax credit is worth more than a tax deduction.
By legally reducing your tax liability, you have more capital available for spending or investing.