You often hear the term "tax shelter" with respect to tax planning. This topic will discuss areas that need to be considered when looking into a tax shelter investment.

A tax shelter is an investment that usually requires substantial investment with a degree of risk. It often involves losses to produce future gains. An investment in low income property that provides depreciation benefits is one example of a legitimate tax shelter. There are several investments you can make that will defer income until a later date, such as Individual Retirement Arrangements (IRAs), retirement plans for self-employed individuals, and deferred annuities, but these are not considered tax shelters because they usually do not involve tax losses. Generally, the amount of your deductions or losses from most activities is limited to the amount that you have at risk. You are considered at risk for an activity to the extent of the sum of the following amounts:

1.The amount of cash you invested in the activity;

2.The adjusted basis of other property you contributed to the activity; and

3.The amount you borrowed to invest in the activity, to the extent that you are personally liable on the loan or have pledged unrelated property as security.

An important note--The losses or credits are often considered passive. They can be used to offset income from passive activities only. They cannot be used against other income such as wages, salaries, professional fees, and portfolio income, such as interest and dividends. The limitations are computed on Form 8582, Passive Activity Loss Limitations.

The excess passive losses and credits generated from tax shelters can be carried forward until you use them up or until you dispose of the tax shelter.

For more information on passive income and losses, refer to Topic 426, or refer to Publication 925, Passive Activity and At- Risk Rules.

An "Abusive Tax Shelter" is a marketing scheme that involves artificial transactions with little or no economic reality. Generally, you invest money to make money. An abusive tax shelter offers you inflated tax savings based on large write-offs and credits. It is often out of proportion to your investment. An abusive tax shelter exists solely to reduce taxes unrealistically, and thus receive an economic benefit. A legitimate tax shelter exists to reduce taxes fairly and also produce income. As in any investment, a real tax shelter involves risks, while an abusive one involves little risk, despite outward appearances. Abusive tax shelters are often marketed in terms of how much you can write-off in relation to how much you invest. This "write-off ratio" is frequently much greater than one-to-one.

A series of tax laws has been designed to halt abusive tax shelters. These include requiring sellers of tax shelters to register them and maintain a list of investors, and requiring investors to report the tax shelter registration number on their tax return using Form 8271, Investor Reporting of Tax Shelter Registration Number.

Investors in abusive tax shelters whose returns are examined may incur a large amount in penalties and interest. Also, promoters of abusive tax shelters may be liable for significant penalties.

For more information about tax shelters, including questions to consider before investing, refer to Publication 550, Investment Income and Expenses.

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