A tax shelter is an investment designed to dramatically lower the investor's income taxes.
The classic tax shelter (which is hard to pull off nowadays without breaking the tax law) is a piece of property that is subject to depreciation, like real estate or heavy machinery. The investor pays for a small fraction of the property, takes out a mortgage secured against the property to cover the rest of the purchase price, and then deducts depreciation on the property every year.
For example, say Jack Investor purchases a $30 million commercial property in New York City. He pays $1 million out of pocket, and gets the remaining $29 million from a bank. The bank has the right to repossess the property if Jack fails to make the loan payments. If the building is depreciable over 30 years, Jack receives a $1 million deduction on his taxes every year for 30 years. Since he's probably in a high tax bracket, he'll get back his million-dollar investment within a few years, and the rest is gravy. (If he pays for a smaller portion of the property, he'll get an even better return on investment.)
The downside to this deal is that at the end of 30 years, the property will have a basis of zero. This means that when the property is sold, the investor will realize a gain on their taxes of the sale price plus the $29 million they "gain" from not being subject to the loan any more. And that makes the deal seem more like a deferral than an actual shelter: the tax liability is just "passed forward" into the future. There are three solutions to this problem:
- Hold on to the property and keep making the mortgage payments. Not particularly attractive.
- Sell the property, but reinvest the proceeds in a bigger tax shelter, or in multiple tax shelters, so as to bury the gain in even bigger deductions.
- Die. When Jack dies, the basis of the property is reset to its fair market value. If the building is still worth $30 million, Jack's heir(s) can sell it for $1 million cash and will recognize no gain on their taxes.
Besides land and buildings, another common tax shelter is large aircraft. Many airlines nowadays don't own their planes; they lease planes from other firms, many of which exist as tax shelters for wealthy individuals.
Obvious disclaimer: Don't rely on pseudonymous authors for tax advice.