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.

An investment that allows one to legally avoid some taxes. Individual retirement accounts and municipal bonds could be considered tax shelters because one does not pay taxes on them. A tax shelter can also be in the form of a business or investment loss, which can be deducted from taxable income.

The purchase of a potentially appreciable asset such as a stock, a bond, a property, or a unit of production. The purchase provides funds for the growth of businesses and governments.

A payment to federal, state, and/or local governments based on the sales price of a product, on worker income, or on other property and activities.

The chance of loss due to the uncertainty of future events. Risks can be in political systems, unforeseen changes in management, investor emotions, etc. Uncertainties in exchange rates, interest rates, inflation, loss of principal, etc. are also considered risk.

1. In financial terms, the result of expenses exceeding income. 2. A reduction in the value of an investment.

1. Income from labor or investments; taxable income is the income left after the standard deduction or itemized deductions and any exemptions have been subtracted. 2. In estate planning, the income of an estate or trust after all deductions have been subtracted.

Income from investments for which the investor was not considered materially involved or did no work.

1. To buy and sell securities for anticipated profit. 2. Commerce, buying and selling, and exchanging of goods for money.

1. An entity that engages in commercial activities in some particular sector, such as industry, retail, or professional services. 2. The commercial activity in which a business engages.

The agency of the federal government that is responsible for collecting federal income and other taxes and enforcing the tax laws of the US government.

An investment in which the investor does not take any role in the management or operation of the investment, as defined by IRS rules and regulations.

The monetary return on one's labor or investments. Income may be wages, salaries, bonuses, dividends, or interest.

Land and the physical property attached to it, such as houses, buildings, factories, and trees. Where applicable by law, real estate may include gas and oil leases.

Residential property leased to others in order to generate income.

Amounts subtracted or withheld from one's gross income. Some deductions, such as taxes, are required by law. Others are elective. For example, you might have the option of putting part of your earnings aside in a pension plan, individual retirement account (IRA), or other savings account. You also might instruct a financial institution to automatically regularly deduct a loan payment so that you don't have to remember to write a check each month. Deductions are also called payroll deductions.

A value calculated on an IRS income tax form from all sources of income plus or minus certain IRS modifications and from which deductions and allowances can be taken to determine taxable income.

Revenue derived from active participation in a business, whether as an owner or an employee. Active income includes wages, salaries, etc.

A fee an investor pays a broker for executing a transaction--buying or selling stock. The commission may be a flat fee, for example, $75.00 per trade; it may be set at a certain amount per share of stock involved in the transaction; or it may be based on the total value of the transaction.

The medium of exchange used in trade or commerce.

Usually longer than one year, often in reference to loans, bond maturities, or capital gains.

Profits from investments held one year or less. They are taxed as ordinary income.

A dollar-for-dollar reduction in a taxpayer's tax payment granted by the IRS to taxpayers who meet certain requirements.

The amount of money that one is required by law to pay to a taxing authority, such as the IRS.

1. Wealth in the form of cash or property that can be used to earn income. 2. The net worth of a business, which is the amount by which its assets are greater than its liabilities. 3. What one owns free and clear.

What Is a Tax Shelter?

Tax Sheltering