What is a tax shelter?
In the traditional sense, a tax shelter is simply a method that a taxpayer uses to generate tax deductions and credits by investing in “investment activities” that often are not expected to generate any real profits. Historically, taxpayers specifically entered into these transactions with the anticipation of producing losses that could be used to offset a taxpayer’s otherwise taxable gains.
Example: Simon has annual income of $450,000 and dividend income of $30,000. He invests $40,000 in a 10 percent interest in ABC partnership (“ABC”), which is in the business of breeding racehorses (Simon had no active role in ABC’s business). ABC, through the use of $800,000 in nonrecourse financing and $200,000 in cash, purchased several horses as a part of this breeding program. After depreciation, interest and other deductions relating to the breeding program, ABC experiences a loss of $500,000. Simon’s share of the loss is $50,000 (10 percent). Even though Simon only actually invested $40,000 in the partnership (and could have only lost $40,000 if the investment subsequently became completely worthless), he would have been entitled to deduct his entire $50,000 share in ABC’s loss.