| We hear about tax shelters all the time, but the average taxpayer is not quite sure whether they are good or bad. It is impossible to categorize all tax shelters as either good or bad. Each must be looked at separately and carefully to determine whether it is legitimate or abusive.
A tax shelter is an investment that generally requires a substantial contribution and that involves a degree of risk. A typical tax shelter often involves current losses to produce future gains. Under most circumstances, the amount of a taxpayer's deductions or losses from most activities is limited to the amount he or she has at risk. A taxpayer is at risk for the following: the amount of cash invested in an activity; the adjusted basis of property contributed to the activity; and the amount borrowed to invest in the activity for which the taxpayer is personally liable.
Tax shelter trade or business activity losses or credits are considered passive activity losses or credits and may, therefore, only be used to offset income from other passive activities. They may not be used to offset other types of income such as wages, salaries, professional fees, or interest and dividends. If a tax shelter generates more passive activity losses than can be used in any year, they can be carried forward into future years until used or until the taxpayer sells his interest in the tax shelter.
There are many legitimate tax shelters in which a taxpayer may be involved. A legitimate tax shelter exists to legally reduce taxes and also to produce income. However, unscrupulous promoters frequently sell schemes by promising a larger write-off than the amount invested. These shelters are often based on transactions that have little or no economic foundations. While all investments, including tax shelters, involve risks, abusive tax shelters involve little risk despite the outward appearance of the arrangement.
Congress has passed a series of tax laws in an attempt to put an end to these abusive tax shelters. These laws include a registration requirement for organizers of tax shelters. In addition, advisors are required to maintain a list of investors, and investors must now disclose any tax shelters in which they are involved and the registration number of those tax shelters.
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