What is a Tax Shelter and How Does It Work?

What is a Tax Shelter and How Does It Work?

Posted by on Feb 25, 2021

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Merriam-Webster defines the term “shelter” as: 

  • Something that provides protection
  • An establishment that houses and feeds strays or unwanted animals

Delving into this a little further, a “tax shelter” isn’t too far off the first definition’s mark, while having nothing to do with the second. Turning back to Merriam-Webster, a tax shelter is defined as:

  • An entity, such as a partnership or investment plan, formed with tax avoidance as a main purpose
  • An interest offered or purpose, with the goal of providing favorable tax consequences

Homeless animals aside, tax shelters are in place to, well, help reduce taxable income. Speaking of definitions, we, at Realized Holdings, note that a tax shelter can “include both investments and investment accounts that provide favorable tax treatment, as well as deductions as laid out by the Internal Revenue Service (IRS).”

Your 401(k) or IRA account? A tax shelter. Interest expenses and depreciation on your annual tax return? Tax shelter. Medical savings accounts or workplace benefits? The same. Basically, a tax shelter is something that can either reduce or eliminate taxes you might incur on ordinary income or capital gains.

How tax shelters work

Tax shelters are a form of tax avoidance, which calls for another definition. Tax avoidance uses legal methods, approved by the IRS, to claim as many allowable deductions or credits on your tax return as possible. The following are examples of how tax shelters work.

Retirement savings. Contributions to an IRA or 401(k) account allows you to defer taxes until you withdraw funds. If that IRA is a Roth IRA, it means you have to pay those taxes upfront, but can withdraw from the account without paying taxes. Regardless of the type of IRA or 401(k) in which you invest, capital gains earned while your money is in that account are tax-free.

Mortgage interest. The mortgage interest deduction is an itemized deduction that allows you to deduct the interest you pay on any loan you take out to buy, build, or make improvements to your home or residence. While you are not putting money into a tax-shelter account, the interest is deducted from your taxable income, potentially reducing your tax liability.

Real estate investments. Whether you have direct ownership of a real estate property or buy fractional shares of a Delaware Statutory trust, you are, in a sense, sheltering some of your income. If you hold those investments for longer than a year, any profit will be taxed at a long-term capital gains rate, versus the pricier ordinary income tax rate. You could, in fact, buy and/or invest in a no-kill animal shelter, and use that to shelter some of your income. Speaking of real estate acquisitions . . .

1031 exchange. The 1031 exchange isn’t so much a tax shelter, as much as it’s a process to help defer taxes on capital gains, by relinquishing one commercial real estate property into a replacement real estate property of equal or greater value.

Keeping it legal

Tax shelters sometimes gain a bad reputation, because they are compared to their more sinister cousin, tax evasion, which is patently illegal. Tax evasion is the illegal non-payment or underpayment of actual tax liabilities that are due, and has nothing to do with tax shelters. As an aside, don’t worry if you accidentally underpay taxes for a given year. The IRS is more concerned about a specific intent to evade, versus forgetting to include an extra few thousand dollars on your wages and benefit statement 10 or so years ago.

While tax shelters offer a good way to lower the amount you might owe to the IRS, it’s always a good idea to check with your accountant, CPA, or tax attorney to ensure that your tax avoidance shelters and deductions are within the realm of legal requirements. Along those lines, more often than not, you can’t use your dog or cat as a dependent or tax shelter, to lower your ordinary income.

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. It should also not be construed as advice, meeting the particular investment needs of any investor.

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