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Tax Shelters

What is a Tax Shelter?

A tax shelter is a method, transaction, or investment that yields tax benefits to the investor. The Internal Revenue code is deliberately structured to allow us to take advantage of legitimate tax shelters to ensure certain social and economic benefits intended by Congress. In these cases Congress has concluded that the resulting loss of revenue is an acceptable side effect of a special tax provision specifically designed to encourage certain kinds of investments. Therefore, tax shelters are not necessarily abhorrent financial practices. In fact, the residence you own is a form of tax shelter since your mortgage interest expense and real estate taxes are deductible items that offset your otherwise taxable income.

The vast majority of tax shelters are in full compliance with the tax laws, but an increasing number of them have crossed the bounds into being "abusive tax shelters". These are cases where the revenue loss to the government produces little or no tax benefit to society.

In order to understand why Congress deliberately allows tax shelters, keep in mind that the country's economy requires the commitment of huge sums of money, often over long periods of time, for leasing; drilling for gas and oil; mining; farming; building tankers, and constructing apartment buildings, shopping centers, and office buildings. This combination of time and money lends itself to operations which result in tax avoidance, both proper and improper. Participants use different investment vehicles to pool their financial resources and accumulate financial benefits. These vehicles differ not only in form but in right of control, participation in management, personal liability, flexibility, and a vast array of elements involved in carrying out their operations or functions. It is because of the many different variations available for structuring financial and tax arrangements that most tax shelters are created.

Even though the Tax Reform Act of 1986 made many tax shelters undesirable to many investors, they are not yet dead, and taxpayers still need to know how to avoid an abusive tax shelter.

Characteristics of a Tax Shelter

Many tax shelters are business ventures in which accounting losses far exceed the accounting income. These losses are used to offset the taxpayer's income from other sources.

Usually, a tax shelter also provides large deductions in its early years although the taxpayer may not have invested significant amounts of capital up front. For example, a taxpayer might purchase a rental property with a low down payment and offset his rental income with deductions for interest, taxes, and the maximum allowable depreciation.

Generally, losses are generated in the first years of existence and passed through to investors, who sometimes achieve a complete return of their original investment through tax savings in the first two or three years. But the existence of a loss does not always indicate a tax shelter. A loss may also occur as a result of business operations or from an unusual event such as a casualty loss. The key element which distinguishes a tax shelter loss from a true business loss is the substance of the event which gave rise to the loss.

There are many methods by which taxpayers shelter their losses, but these three characteristics are usually found in tax shelters, either separately or in combination:

• Taxes are deferred to later years.
• Ordinary gains (100 percent taxable) are converted to capital gains (only 40 percent taxable), or capital losses (only 50 percent deductible), are converted to ordinary losses (100 percent deductible); in both cases producing a lower tax liability (valid until 1987).
• Leverage is obtained through various financing arrangements.

Deferral means the postponement of income taxes. In general, a significant portion of the tax shelter investor's return is derived from "pass-through" deductions used to offset ordinary income from other sources- thus creating significant tax benefits. The tax shelter allows the taxpayer to postpone or even avoid payment of taxes. The deferral of taxes is the equivalent of an interest-free loan from the Government, the economic benefits of which can be significant.

An example of deferral is an IRA, your Individual Retirement Arrangement. The tax on your current year's income that has been placed in an IRA is deferred until you withdraw the funds at retirement, when your annual income and tax bracket should be lower.

Deferral also occurs when excessive deductions are taken in the early years of a tax shelter, a practice the IRS calls "front end loading." Examples of illegal front end loading practices are:

• Deducting capital items by classifying them as advisory fees, management fees, or interest.
• Deducting prepaid interest.
• Not including prepaid income.
• Deducting excessive depreciation, amortization, or depletion by using the wrong method, too short a useful life; and/or too large a basis.

Conversion means converting ordinary income items into capital gains or converting capital losses into ordinary losses to reduce taxable income (no longer a characteristic after 1986). Conversions may involve buying a commercial real estate building to obtain a current tax deduction (for example, from a net operating loss on the rental income) against other ordinary income, only to sell it at a later date for a long-term capital gain, which is taxed at a more favorable rate.

For example:
Arnold C. purchased a rental building on January 1, 1984 for $1 million. Mr. C. borrowed the entire amount which was to be repaid over 10 years at 10 percent interest. No principal was paid the first year. Mr. C. reported the following items on his Schedule E for 1984:

Rental income....................................$150,000
Minus: Interest Paid...................$100,000
       ACRS S/L Depreciation.............66,667
       Other operating expenses..........83,333

     Net expenses................................-$250,000
     Ordinary loss for 1984......................($100,000)

On January 5, 1985 Mr. C. sold the rental property for the amount of the unpaid mortgage on the property, which happened to be the same $1 million he paid for it.

Selling price....................................$1,000,000
Minus Adjusted Basis:
    Cost...............................$1,000,000
    Minus: ACRS S/L....................    66,667  -933,333
Long-term capital gain...............................66,667
Minus: Capital gain deduction
(per Internal Revenue Code 1202) (60% of $66,667....-40,000
Taxable gain for 1985...............................$26,667

Ordinary loss of 1984............................($100,000)
Taxable gain for 1985............................+  26,667
Net effect of conversion..........................($73,333)

This two year tax avoidance maneuver resulted in a net $73,333 loss, due mostly to the ACRS depreciation assistance. Basically, for no money down and little risk, Mr. C. received a $73,333 tax deduction which would have been used to offset other taxable income. (Do you ever wonder why the rich get richer?)

Leverage is the ratio of borrowed funds to the amount of at-risk capital invested in an activity or business venture.

The ideal leverage situation for the investor is one in which he enters into a transaction with no down payment whatsoever, buying the property completely on credit. In this situation the taxpayer has no at-risk capital and his or her leverage is 100 to 0. Typically, one of the selling points used by financial advisors to draw investors into a tax shelter scheme is the leverage. The best situation exists when the taxpayer finances his or her investment through a nonrecourse loan. A nonrecourse loan is any borrowing structured so that the borrower has no personal liability and the lender only looks to the specific assets pledged as security in the event of default on the loan. Simply, what makes nonrecourse financing attractive is that in the event that the taxpayer's investment does not result in enough proceeds to pay the note, the taxpayer is not held personally liable to repay the loan balance.

The use of capital through borrowing is the primary attraction of many shelters. At one time, nonrecourse loans enabled high-income investors to deduct losses far greater than the amount personally risked in the investment. An example: purchase agreements that contained a clause stating that the loan would be paid off only from the distribution proceeds or from the eventual sale of the purchased asset. If this clause was in the loan agreement, the loan was a nonrecourse loan and the investor was not personally liable for repayment of the loan, even if the asset produced no income.

Now, under IRC Section 465 (effective after December 31, 1975), a taxpayer's loss is limited to the amount that he has "at risk" and could actually lose from an activity. This prevents a tax loss from exceeding the taxpayer's economic risks. (For more information regarding the "at-risk" rules, see IRS Pub. 536.)

Next Section: Identifying an Abusive Tax Shelter

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© 1986, 1998 to 2002, Jack Warren Wade, Jr.