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What is a Burned out Tax Shelter?

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  • Written By: N. Madison
  • Edited By: Niki Foster
  • Last Modified Date: 17 February 2020
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A burned out tax shelter is a tax shelter that has ceased to provide income tax deductions. If an investment is initially intended to afford significantly large tax deductions, but does not currently do so, it is called a burned out tax shelter. Many tax shelters decrease in effectiveness over a period of time. This is because accelerated-depreciation deductions decrease in size as an asset ages, vanishing when the asset is fully depreciated.

Essentially, a burned out tax shelter can be compared to a business that was once profitable. In the early years of operations, the business may have produced a nice, tidy profit for its owners. As time goes by, however, the business may lose momentum, eventually causing the business owners to lose money instead of turning a profit.

To understand the concept of a burned out tax shelter, consider an example involving net operating income. If a sole proprietor acquires a new business and has a net operating income of 750,000 US Dollars (USD), and depreciation and interest deductions for the year total 1,000,000 USD, the sole proprietor would have a 250,000 USD tax shelter. Years later, however, the same interest and depreciation deductions might only be worth 500,000 USD. In such a case, 250,000 USD of the net operating income would be taxable, and the tax shelter would be considered a burned out tax shelter.

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Once a tax shelter becomes a burned out tax shelter, its original tax benefit cannot be recovered. The taxpayer must either pay the taxes due on the money because of the burned out tax shelter or find another legal tax shelter. Unfortunately, this is not always easy or even possible to do, and many taxpayers have to ante up on their taxes.

The subject of tax shelters can be quite controversial. Some individuals view them as legitimate investment opportunities with significant tax worth. On the other side, some view tax shelters as loopholes in the tax code that work to hamper the reduction of the national debt.

It is also important to note that some tax shelters are illegal. To stay on the right side of the law when employing a tax shelter, it is best to consult with a qualified tax professional. Such a professional may also be able to come up with legitimate ways to ease the tax situation caused by a burned out tax shelter.

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