A tax shelter is an investment that usually requires substantial investment with a degree of risk. It often involves current losses to produce future gains. An investment in low income property that provides depreciation benefits is one example of a legitimate tax shelter. 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 for 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 property not used in the activity as security.

Note: The losses or credits created by tax shelters are often considered passive. Such losses or credits may only be used to offset income from other passive activities. They cannot be deducted against other income such as wages, salaries, professional fees, or 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 can use them or until you dispose of the tax shelter.

For more information on passive income and losses, refer to Topic 425, or Publication 925.

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. An "Abusive Tax Shelter" is a marketing scheme that involves artificial transactions with little or no economic foundation. Generally, you invest money to make money. An abusive tax shelter offers you inflated tax savings based on large write-offs and credits which are often out of proportion to your investment. An abusive tax shelter exists solely to reduce taxes unrealistically. 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 tax shelter involves little risk, despite outward appearances.

A series of tax laws has been designed to halt abusive tax shelters. These laws include requiring sellers of tax shelters to register them using Form 8264, Application for Registration of a Tax Shelter 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 be required to pay more tax, penalties, and interest. Also, promoters of abusive tax shelters may be liable for significant penalties.

There are several other investments you can make that will defer income until a later date, such as Individual Retirement Arrangements, retirement plans for self-employed individuals, and deferred annuities. But these are not considered tax shelters because they usually do not involve tax losses. For more information concerning tax shelters, including issues to consider before investing, see Publication 550, Investment Income and Expenses. Publications and forms may be downloaded from this site or ordered by calling 1-800-829-3676.

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