Tax shelters still exist and can save you money

By Jeff Schnepper

Tax shelters are not a thing of the past. Some taxpayers have wrongly assumed that recent changes in our 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 (we hope), to serve some major economic or social goal.

A tax shelter is any investment designed to reduce or avoid income taxes. This is not bad. Former Internal Revenue Service 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.

Real estate is the most popular shelter. Indeed, it's such a good tax shelter that as Rep. Pete Stark put it memorably, "It'd take a genius to invest in real estate and pay taxes." Real estate provides leverage, an inflation hedge, cash flow and equity buildup.

As your property appreciates in value, 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 loses money. Remember, in the 28% tax bracket in 2005 or 2006, a $5,000 paper deduction for depreciation creates a real cash tax savings of $1,400. This tax-generated cash can be used for any operating expense deficit.

Moreover, as you pay down the mortgage, you're building equity. 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 -- especially with oil prices north of $50 a barrel. 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 completing a well are deductible in the year incurred. Normally, you would not be allowed to deduct these expenditures until the year that either the product was actually extracted from the wells or the drilling was abandoned.

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

The downside is there are never any guarantees 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 in wildcatting, as exploratory drilling is known.

Keep in mind, however, that as you reduce your risk, you also reduce your potential investment profit. Wildcatting produces the greatest returns, but it also has the lowest probability of success.

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