A tax shelter is an investment that generates either tax-deferred or tax-exempt income. A tax shelter takes advantage of various aspects of the tax code. For example, it may do any of the following:
- Generates tax-deductible losses via the use of depreciation or interest expenses
- Takes advantage of incentive tax deals
- Takes advantage of the interest exemption on government debt
An example of a tax shelter is a SEP IRA investment account, in which a person places funds for which taxable income will not be due until the person reaches retirement age (and at which point the person will presumably be in a lower tax bracket). Another example is municipal bonds, for which the interest income is usually tax exempt.
A tax shelter is considered to be abusive if it exists primarily to reduce taxes to an inordinate extent. The IRS can impose fines and penalties when it decides that a tax shelter is abusive. A tax shelter is usually not considered to be abusive when it involves a risk of loss that is proportionate to the amount of the investment.