Understanding (Legal) Tax Shelters
Everything you do to reduce your tax bill technically counts as a tax shelter. Essentially, you are sheltering your income from being eaten away by taxes. You can accomplish this two ways: defer the tax bill (such as when you put money into retirement accounts) or avoid it completely. Tax shelters include investments, special investment accounts, and planning strategies that either lower your current taxable income or offer favorable tax treatment to your income.
The IRS always keeps an eagle eye on tax shelters. It looks for investments made solely for the purpose to evade taxes. And if they recharacterize your transaction, you could be hit not only with current taxes but also further taxes and penalties. Remember, it's okay to minimize your tax bills — even reduce them to zero — but tax evasion is illegal.
Real estate investment is one of the best tax shelters available. In fact, it's by far the most popular. That's largely due to the depreciation deduction you get on investment properties (especially rental properties). Depreciation is an on-paper expense, meaning you don't pay for it right now. The related tax deduction, though, puts real money in your pocket, or at least reduces the money you'll pay in taxes.
Novice investors don't use most other investment tax shelters. Oil and gas investments, for example, offer big deductions for drilling and developing costs. Investors typically take part in these investments through limited partnerships, usually found by their investment advisors. These investments do come with a downside, though: Your investment may not pay off if oil is not found, leaving you with deductions but no income to offset them with. Other tax-sheltered investments (again, usually purchased in the form of partnership shares through investment advisors) include equipment leasing and cattle breeding.
If you're looking for real life ways to shelter your investment earnings from taxes, there are a few very simple steps you can take. Whenever possible, hold on to investments longer than one year. Put as much money as you can into tax-sheltered accounts like IRAs and 401(k) plans and college savings accounts. Bump up your itemized deductions by remembering to take credit for all of your investment expenses. And work closely with your tax preparer, who can make sure you take advantage of every possible loophole available to you.