How Does Depreciation Affect Tax Shields?

How Does Depreciation Affect Tax Shields?

Posted by on Jan 3, 2022

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Tax shields are named so because they help to shield income from taxes. By taking various forms of tax deductions, income can be offset (i.e., reduced), resulting in a lower tax bill. The type of tax shield depends on the individual, business, and country they are living in.

If you already have a tax shield in place, can you still deduct depreciation expenses? In other words, can you use more than one type of deduction, and how do they affect the tax shield? Those are the questions we’ll answer in this article.

What is a Tax Shield?

A tax shield is a strategy that helps reduce (sometimes to zero) tax liability. There are many different types of tax shields that range from the simple to the more complex.

Some simpler and common tax shields are businesses that reduce taxable income through expenses. Most business owners will be familiar with this strategy. By accumulating expenses that are valid tax deductions, business owners can reduce their taxable income. The more expenses, the more taxes can be reduced.

Real estate investors are familiar with the tax advantages of owning real estate property. Related tax shields come in the form of mortgage interest expense, potential business expenses, and depreciation.

Basically, any tax deduction can be a tax shield. 

Some of the more complex tax shields involve moving to a different country that has low or no income taxes. This may include setting up a business in the country to take advantage of its low tax rate. Such countries are called tax havens.

In many cases, the above examples aren’t as easy as filing an LLC in the Bahamas. Often, a country will require you to become a resident or at least spend a lot of your time in the country. If you don’t actually want to live in the country, it can become quite a burden to try and establish a business there just to save on taxes.

Is There a Limit to Tax Shields?

If we are talking about taking multiple different types of deductions, there isn’t a limit on the number of deductions. However, there may be a monetary limit.

For example, you can deduct multiple different types of business expenses against business profit. Depending on the expense, it may have a monetary limit. 

This means if other deductions have been taken, they don’t invalidate taking depreciation expense. Adding depreciation to a tax shield simply increases the number of deductions and further reduces taxable income.

It’s important to note that depreciation is different from most expenses. With most expenses, there is a cash outflow to incur the expense. For example, a business owner buys shelves for her store. The business owner must pay out of pocket for the shelves. 

That isn’t the case with depreciation. Each year, depreciation can be taken against eligible assets. There’s no cash outflow for incurring the annual depreciation expense. However, depending on when the asset is sold, the investor may have to pay depreciation recapture.

Working with a tax adviser is the best route to understanding which expenses can be deducted from a business or investment. But the number of those expenses shouldn’t affect deduction expenses. However, it is best to consult with a tax adviser to be sure.

 

This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.

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