A tax shelter is an investment designed to dramatically lower the investor's income taxes.

The classic tax shelter (which is hard to pull off nowadays without breaking the tax law) is a piece of property that is subject to depreciation, like real estate or heavy machinery. The investor pays for a small fraction of the property, takes out a mortgage secured against the property to cover the rest of the purchase price, and then deducts depreciation on the property every year.

For example, say Jack Investor purchases a $30 million commercial property in New York City. He pays $1 million out of pocket, and gets the remaining $29 million from a bank. The bank has the right to repossess the property if Jack fails to make the loan payments. If the building is depreciable over 30 years, Jack receives a $1 million deduction on his taxes every year for 30 years. Since he's probably in a high tax bracket, he'll get back his million-dollar investment within a few years, and the rest is gravy. (If he pays for a smaller portion of the property, he'll get an even better return on investment.)

The downside to this deal is that at the end of 30 years, the property will have a basis of zero. This means that when the property is sold, the investor will realize a gain on their taxes of the sale price plus the $29 million they "gain" from not being subject to the loan any more. And that makes the deal seem more like a deferral than an actual shelter: the tax liability is just "passed forward" into the future. There are three solutions to this problem:

  1. Hold on to the property and keep making the mortgage payments. Not particularly attractive.
  2. Sell the property, but reinvest the proceeds in a bigger tax shelter, or in multiple tax shelters, so as to bury the gain in even bigger deductions.
  3. Die. When Jack dies, the basis of the property is reset to its fair market value. If the building is still worth $30 million, Jack's heir(s) can sell it for $1 million cash and will recognize no gain on their taxes.

Besides land and buildings, another common tax shelter is large aircraft. Many airlines nowadays don't own their planes; they lease planes from other firms, many of which exist as tax shelters for wealthy individuals.

Obvious disclaimer: Don't rely on pseudonymous authors for tax advice.

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