How To Recognize A Good Tax Shelter

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Year after year clients bombard their accountants with inquiries about tax shelters. Those questions don't seem to have diminished, even though the top individual tax rate tumbled from 70% in 1981 to 50% in January 1982.

The basic guidelines on what makes an appealing -- and legal -- tax shelter are often forgotten. No matter how well the deal works as a tax shelter, if it lacks economic substance -- that is, if it has no attractions other than tax benefits -- you will lose in the long run.

Assume you have found a deal that passes the economic substance test and provides capital appreciation without any special tax benefits. If the deal offers tax shelter besides, all the better. In general, tax shelter means that, after all the smoke clears, you wind up with more aftertax dollars than you would have had in a deal that is not a tax shelter. Deferring tax, providing an investment credit or depreciation, and turning ordinary income into capital gains are conventional ways of accomplishing tax shelter.

Beware these common pitfalls: A typical tax-shelter sales pitch might promise that if you put up $10,000, the deal will offer a 5-to-1 write-off, or $50,000. In a 50% tax bracket, the pitch goes, you save $25,000 in taxes. Since you are putting up only $10,000, you'll be $15,000 ahead by going into the deal.

Unfortunately, it's more complex than that. In most instances, Internal Revenue Service rules prevent you from deducting any more than you have at risk in any tax shelter deal. So if you put up $10,000, or are liable for no more than $10,000, your deduction is limited to $10,000.

Real estate, however, is a noteworthy exception. If you put up $10,000 in cash and borrow $40,000 (through a mortgage on which you have no personal liability beyond the property itself) your deductions in a real estate deal could go as high as $50,000, despite the fact that you are at risk for only $10,000.

Last updated: Aug 1, 1982




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