What Is a Tax Shelter?

When people hear the word tax shelter, they often think of financial strategies used only by the ultra-rich, but this is not the case. Tax shelters are financial instruments that everyone can use. With the right guidance you can set up one too.

A tax shelter, not to be confused with a tax haven, is a financial instrument used by individuals and organizations to lower their taxable income and thus their overall tax liability either permanently or temporarily. Tax shelters are often created by the government to encourage certain sets of behavior, like real estate investing or retirement savings.

You may have already unknowingly put your money into a tax shelter. Does a 401(k) plan sound familiar? Yes, that's right -- your 401(k) is a type of tax shelter. Want to learn more? Let's review how a 401(k) plan and many other types of tax shelters may work in your favor.

Tax-deferred retirement accounts

Though not permanent, one of the most widely used types of tax shelters is a tax-deferred retirement account. This type of tax shelter often takes the form of a 401 K plan or a deductible traditional IRA. Many real estate investors and small-business owners often have self-directed plans.

If you utilize any of these types of accounts, your taxable income will be reduced by the amount of your deductible contribution, and the money you contributed will grow tax free. While you will be sheltered from taxation early in the plan participation, upon distribution, you'll have to pay taxes of any amount distributed to you. For this reason, this type of account is not a permanent tax shelter.

In addition to 401 K plans and tax-deferred retirement plans, you may also be familiar with tax- sheltered annuities.

Tax-sheltered annuity

Most individuals are familiar with 403 (b) plans, also known as TSA plans. In general, 403 (b) plans offer nonprofit and public-education employees a vehicle to invest their retirement savings in. Like 401 (k) plan participants, individuals are able to contribute to their 403(b) plan and the money grows tax free. Taxes are not planned on the contribution to the plan or growth in the plan until there's a distribution from the plan.

In addition to retirement plans, there are many more tax shelters that might interest you. Let's dig in.

Tax shelters for real estate investors

For real estate investors, there are several tax shelters that may be attractive to you and that you should consider before the April 18, 2023 filing deadline.

Section 1031 like-kind exchange

Another type of tax shelter that has garnered a significant amount of attention in recent years is the section 1031 like-kind exchange tax shelter. Under section 1031, investors are allowed to exchange real estate held for business or investment purposes for another property of the same nature and character, even if they are of a different quality (like kind), without recognizing capital gains on the transaction. Thus, the investor will not owe any taxes.

There are many ways to facilitate these types of exchanges. One way is through a Delaware Statutory Trust (DST). DSTs allow accredited investors to take part in section 1031 exchanges without individually owning the property involved in the exchange.

If you'd like to learn more about section 1031 like-kind-exchanges, a complete guide can be found here.

Depreciation

Another popular tax shelter is the depreciation deduction; this deduction is generally claimed by rental property owners. In general, depreciation is a process used in accounting, which allocates the original cost of a capital asset over the useful life of the asset. This deduction is claimed annually on IRS Form 4562. If you own depreciable property and are able to claim the depreciation deduction for the property, you will be able to dramatically lower your taxable income.

Before taking the depreciation deduction on any property, you should consult with your advisor to assist with the exchange. If this exchange is not done properly, you could create a taxable event and thus recognize capital gain.

Accelerated depreciation

Accelerated depreciation is a method used in accounting where taxpayers are able to claim a greater depreciation expense in the early life of a capital asset. Some popular methods are the double declining balance method and bonus depreciation. For our purpose, we will focus on bonus depreciation.

Bonus depreciation

Bonus depreciation is an accounting method that allows taxpayers to immediately deduct a large portion of the capital the year the asset is placed in service. For assets with a useful life of less than 20 years, the IRS allows taxpayers to claim 100% bonus depreciation on the capital asset. As a tax shelter, this depreciation will allow eligible individuals to significantly reduce their income.

Stepped-up basis

Like 401(k) plans, the concept of stepped-up basis may be very familiar to you. Individuals normally receive a stepped-up basis in property when they inherit the property from a decedent. When this type of exchange occurs, the beneficiary’s basis in the property is the same as the decedent’s basis on the date of death. In this instance, the beneficiary receives a stepped-up basis.

For example, hypothetical Sarah’s long-lost uncle, Mr. Monopoly, dies on January 1, 2023, and leaves hypothetical Sarah a mansion as part of his will. In 1985, Mr. Monopoly acquired the mansion for one million dollars. On January 1, 2023, the mansion was valued at 10 million. Hypothetical Sarah’s basis in the mansion is 10 million dollars, and as such, she will recognize no gain or loss when she takes the property, and thus she will not have a tax liability; the transaction is "sheltered" from taxation.

Receiving a stepped-up basis is the type of tax benefit that many individuals have enjoyed for decades. The tax code surrounding stepped-up basis is currently under review by the Biden administration, and some changes may be made to this provision. While there may be some changes in the future, for now beneficiaries can continue to receive a stepped-up basis in inherited property.

The bottom line

Whether it's receiving a stepped-up basis in inherited property or investing in a 401 (k) plan, tax shelters are a phenomenal tool that anyone can use to lower their tax bill. While tax shelters are a phenomenal financial tool, they are heavily regulated and monitored by the IRS. As such, if you're interested in investing in one, it's best to work with a financial advisor to develop the best strategy for you.