Tax Shelters: Still Alive and Well

TAXES

By Jeff Schnepper

Decision Center

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Ask the Experts

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Three Elements of a Tax Shelter

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RESOURCES

Cost Depletion

Cost depletion is computed by dividing the estimated total units (barrels of oil or 1,000 cubic feet of gas) that can be recovered from the property into its adjusted tax basis in order to get the per unit depletion allowance. Your deduction is calculated by multiplying the number of units sold during the year.

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RESOURCES

Percentage Depletion

Percentage depletion allows you to deduct as much as 15 percent of your gross revenue. Percentage depletion is almost always greater than cost depletion. For example, if a well is drilled on a lease that costs $2,000 and yields an estimated 100,000 barrels of recoverable reserves, the rate of cost depletion for that property would be 2 cents per barrel of oil produced ($2,000 divided by 100,000). This is far less than the percentage depletion at the applicable rate. Fifteen percent of the gross income of oil selling at $20 per barrel is $3. The net impact of the depreciation and depletion reductions is that with normal operating expenses, from about a third to a quarter of your income from the well is tax-free.

ax shelters are not a thing of the past. Some taxpayers have wrongly assumed that recent changes in the nation's tax laws eliminated these government-sponsored programs. Not a chance. But if you still believe that, you could end up paying too much in taxes.

Tax shelters have been described by the unsophisticated as gimmicks or "loopholes." The fact is, Congress created these loopholes after careful deliberation, to serve some major economic or social goal. Therefore, when you use these techniques, you are not only improving your own financial position, you are furthering a legitimate national economic goal.

A tax shelter is any investment designed to reduce or avoid income taxes. This is not bad. Former IRS Commissioner Donald Alexander once said, "As a citizen, you have an obligation to the country's tax system, but you also have an obligation to yourself to know your rights under the law and possible tax deductions - and to claim every one of them."

Traditional tax shelters have included investments in real estate, oil and gas, equipment leasing, and cattle feeding and breeding programs.

House Ways and Means Committee member Fortney H. (Pete) Stark, D-Calif., once remarked, "It'd take a genius to invest in real estate and pay taxes." Real estate is a great tax shelter. It provides leverage, an inflation hedge, cash flow and equity buildup.

As your property appreciates, you are allowed a paper deduction for depreciation. If structured correctly, you buy the property with your down payment. Hopefully, your rents cover your mortgage interest, taxes and operating expenses.

But it's possible to come out ahead, even if the property lost money. Remember, in the 31 percent tax bracket, a $5,000 paper deduction for depreciation creates a real cash tax savings of $1,550. This tax-generated cash can be used for any operating expense deficit.

Moreover, as you pay your mortgage, you're building equity with your principal pay-down. It's a win-win situation. Once your mortgage is paid off, you have an annuity in perpetuity (rents), while your investment appreciates in value. The downside is that you must buy property that WILL appreciate in value and, if you want to deduct your losses, you must be actively involved in its management.

Oil and gas investments are other popular tax shelters. With oil and gas, you're allowed to deduct as a current expense your investments in capital expenditures known as intangible drilling and developing costs. Nearly all the costs of drilling and well completion costs are deductible in the year incurred. Normally, you would not be allowed to deduct these expenditures until the drilling was either abandoned or the product was actually extracted from the wells.

Moreover, with these investments, you can use either cost depletion or percentage depletion.

The downside is there are never any guarantees that you will hit oil or gas. These deductions lose their shine when there is no income to offset them. You can minimize your risk by investing in development or combination programs rather than exploratory drilling known as wildcatting. Keep in mind, however, that as you reduce your risk, you also reduce your potential investment profit. Wildcatting produces the greatest returns, but has the smallest probability of success.

With equipment leasing, your shelter comes from accelerated deductions and the use of leverage in structuring the investment.

In the early years, you can actually deduct more than the cash you put into the deal. However, in the later years, you may have what is known as "phantom income." This is where your taxable income is greater than your cash inflow. By taking the deductions in the earlier years, there are fewer deductions available in the later years. While the amount of interest you pay on your investment loan is reduced, the payment itself is not. You are now paying principal, which is not deductible. Nevertheless, structured correctly, an equipment leasing shelter gives you the opportunity to get an interest-free loan from the IRS by paying less in taxes today and making it up tomorrow.

Make sure economic reality and a profit objective, rather than just the availability of tax deductions, drive your investments. If you are just looking for a deduction, send me a check. I will be happy to send you a receipt for a tax consultation that would clearly be allowed. However, even in the top 39.6 percent tax bracket, you would still be out of pocket 60.4 percent of what you paid me!

Cattle feeding and breeding shelters also offer tax savings by accelerating the deductions and the potential exchange of ordinary deductions for capital gains. However, the economics of these programs can be seriously affected by the cyclical market price of cattle. They're not for the unsophisticated.

Certain shelters should be avoided completely. These include art reproduction shelters and non-cash gift shelters. Both of these are frauds that will almost guarantee you an unhappy audit. Single premium life insurance and tax straddles have legislatively lost their tax shelter elements and no longer provide the tax savings opportunities of the past. While they might make sense on an economic basis, using them as a tax shelter won't work.

This column has sought to examine the various tax shelter opportunities currently available on the market. My next column will detail how to evaluate a tax shelter and, when desired, how to get out of a tax shelter.

A tax shelter is any investment designed to reduce or avoid income taxes.

Real estate is a great tax shelter. It provides leverage, an inflation hedge, cash flow, and equity buildup.

Tax Shelters: Still Alive and Well

Articles

Five Basic Tips to Cut Your Tax Bill
Start Planning Now for Next Year's Taxes
IRAs and Other Tax-Deferred Retirement Plans

Next Steps

Go to Money's Tax Estimator Worksheet

	TAXES

	Tax Shelters: Still Alive and Well By Jeff Schnepper Decision Center

.......................................... WEB LINK Ask the Experts .......................................... SIDEBAR Three Elements of a Tax Shelter .......................................... RESOURCES Cost Depletion Cost depletion is computed by dividing the estimated total units (barrels of oil or 1,000 cubic feet of gas) that can be recovered from the property into its adjusted tax basis in order to get the per unit depletion allowance. Your deduction is calculated by multiplying the number of units sold during the year. .......................................... RESOURCES Percentage Depletion Percentage depletion allows you to deduct as much as 15 percent of your gross revenue. Percentage depletion is almost always greater than cost depletion. For example, if a well is drilled on a lease that costs $2,000 and yields an estimated 100,000 barrels of recoverable reserves, the rate of cost depletion for that property would be 2 cents per barrel of oil produced ($2,000 divided by 100,000). This is far less than the percentage depletion at the applicable rate. Fifteen percent of the gross income of oil selling at $20 per barrel is $3. The net impact of the depreciation and depletion reductions is that with normal operating expenses, from about a third to a quarter of your income from the well is tax-free.	ax shelters are not a thing of the past. Some taxpayers have wrongly assumed that recent changes in the nation's tax laws eliminated these government-sponsored programs. Not a chance. But if you still believe that, you could end up paying too much in taxes. Tax shelters have been described by the unsophisticated as gimmicks or "loopholes." The fact is, Congress created these loopholes after careful deliberation, to serve some major economic or social goal. Therefore, when you use these techniques, you are not only improving your own financial position, you are furthering a legitimate national economic goal. A tax shelter is any investment designed to reduce or avoid income taxes. This is not bad. Former IRS Commissioner Donald Alexander once said, "As a citizen, you have an obligation to the country's tax system, but you also have an obligation to yourself to know your rights under the law and possible tax deductions - and to claim every one of them." Real estate is a great shelter Traditional tax shelters have included investments in real estate, oil and gas, equipment leasing, and cattle feeding and breeding programs. House Ways and Means Committee member Fortney H. (Pete) Stark, D-Calif., once remarked, "It'd take a genius to invest in real estate and pay taxes." Real estate is a great tax shelter. It provides leverage, an inflation hedge, cash flow and equity buildup. As your property appreciates, you are allowed a paper deduction for depreciation. If structured correctly, you buy the property with your down payment. Hopefully, your rents cover your mortgage interest, taxes and operating expenses. But it's possible to come out ahead, even if the property lost money. Remember, in the 31 percent tax bracket, a $5,000 paper deduction for depreciation creates a real cash tax savings of $1,550. This tax-generated cash can be used for any operating expense deficit. Moreover, as you pay your mortgage, you're building equity with your principal pay-down. It's a win-win situation. Once your mortgage is paid off, you have an annuity in perpetuity (rents), while your investment appreciates in value. The downside is that you must buy property that WILL appreciate in value and, if you want to deduct your losses, you must be actively involved in its management. Oil and gas: no guarantees Oil and gas investments are other popular tax shelters. With oil and gas, you're allowed to deduct as a current expense your investments in capital expenditures known as intangible drilling and developing costs. Nearly all the costs of drilling and well completion costs are deductible in the year incurred. Normally, you would not be allowed to deduct these expenditures until the drilling was either abandoned or the product was actually extracted from the wells. Moreover, with these investments, you can use either cost depletion or percentage depletion. The downside is there are never any guarantees that you will hit oil or gas. These deductions lose their shine when there is no income to offset them. You can minimize your risk by investing in development or combination programs rather than exploratory drilling known as wildcatting. Keep in mind, however, that as you reduce your risk, you also reduce your potential investment profit. Wildcatting produces the greatest returns, but has the smallest probability of success. Equipment leasing: structure correctly With equipment leasing, your shelter comes from accelerated deductions and the use of leverage in structuring the investment. In the early years, you can actually deduct more than the cash you put into the deal. However, in the later years, you may have what is known as "phantom income." This is where your taxable income is greater than your cash inflow. By taking the deductions in the earlier years, there are fewer deductions available in the later years. While the amount of interest you pay on your investment loan is reduced, the payment itself is not. You are now paying principal, which is not deductible. Nevertheless, structured correctly, an equipment leasing shelter gives you the opportunity to get an interest-free loan from the IRS by paying less in taxes today and making it up tomorrow. Make sure economic reality and a profit objective, rather than just the availability of tax deductions, drive your investments. If you are just looking for a deduction, send me a check. I will be happy to send you a receipt for a tax consultation that would clearly be allowed. However, even in the top 39.6 percent tax bracket, you would still be out of pocket 60.4 percent of what you paid me! Cattle shelters not for novices Cattle feeding and breeding shelters also offer tax savings by accelerating the deductions and the potential exchange of ordinary deductions for capital gains. However, the economics of these programs can be seriously affected by the cyclical market price of cattle. They're not for the unsophisticated. Certain shelters should be avoided completely. These include art reproduction shelters and non-cash gift shelters. Both of these are frauds that will almost guarantee you an unhappy audit. Single premium life insurance and tax straddles have legislatively lost their tax shelter elements and no longer provide the tax savings opportunities of the past. While they might make sense on an economic basis, using them as a tax shelter won't work. This column has sought to examine the various tax shelter opportunities currently available on the market. My next column will detail how to evaluate a tax shelter and, when desired, how to get out of a tax shelter.	A tax shelter is any investment designed to reduce or avoid income taxes. Real estate is a great tax shelter. It provides leverage, an inflation hedge, cash flow, and equity buildup.
	Tax Shelters: Still Alive and Well
	Articles \|

	Five Basic Tips to Cut Your Tax Bill Start Planning Now for Next Year's Taxes IRAs and Other Tax-Deferred Retirement Plans

	Next Steps \|

	Go to Money's Tax Estimator Worksheet Illustration by James O'Brien Copyright 1998 Microsoft Corporation