Abusive tax shelters are a consequence that resulted from Congress allowing losses of revenue to be used for tax benefits. They are a side-effect of tax deductions that companies are entitled to claim; however, when the claims are exaggerated, those tax deductions change from tax shelters to abusive tax shelters, with the latter being illegal and actual tax fraud.
The abusive tax shelter is a type of investment that is considered illegal as it allegedly diminishes the income tax liability of an investor without affecting the investor’s income or their assets. The real purpose of abusive tax shelters is to lower an investor’s federal and income tax. They work through complex transactions that include partnerships, trusts, or other legal entities. They might use legal entities, but they should not be confused with tax shelters that are legitimate and are not considered abusive.
Regardless of what type of investor they are, taxes are important as they affect the investor’s profit in property, business, or other types of investments. It is for that reason why real estate investors try to find as many ways possible to reduce their tax liability in a legal manner.
What investors need to know, however, is to differentiate between the legal and illegal ones. Abusive tax shelters are marketing ploys that use financial techniques to inflate appraisals, set unrealistic allocations, and mismatch incomes and deductions to reduce an investor’s tax liability in ways that don’t respect standard business practices. The most frequent marketing strategy for abusive tax shelters is to present how much an investor can deduct for every dollar spent.
The Internal Revenue Service (IRS) considers overstating expenses, such as depreciation or other illegal write-offs by real estate owners’ abusive tax shelters. If the write-offs are disallowed, the taxpayer must pay back taxes, interest, and penalties.
In their war against abusive tax shelters, the IRS Office of Tax Shelter Analysis has organized a strategy to identify and stop those who popularize them through every method at their disposal: audits, targeted litigations, and summons enforcement. The IRS also created a list where every investor can find abusive tax shelters to avoid disclosing the promoters or participants of these abusive tax shelters. The last step is to implement other ways that can help taxpayers resolve abusive transactions.