Tax Shield Definition

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Tax Shield Definition

What Is a Tax Shield?

A tax shield is a decrease in taxable income accomplished by claiming permitted deductions such as mortgage interest, medical expenditures, charitable contributions, amortization, and depreciation. These deductions can lower a taxpayer’s taxable income for the current year or delay income taxes for future years. Tax shelters reduce the total amount of taxes owing by a person or a corporation.

Breaking Down Tax Shield

The phrase “tax shield” refers to a deduction’s capacity to protect a portion of a taxpayer’s income from taxes. Tax shelters differ from nation to country, and their advantages are determined by the taxpayer’s total tax rate and cash flows for the tax year in question. Because interest payments on some loans are tax deductible, taking on eligible obligations may operate as tax shelters. Tax-efficient investment techniques are essential for high-net-worth people and organizations with large yearly tax expenditures.

The following formula may be used to calculate the tax shield:

Tax Shield = Value of Tax-Deductible Expensex Tax Rate

So, if you pay $1,000 in mortgage interest and your tax rate is 24%, your tax shield will be $240.

Tax Shields as Incentives

The option to utilize a house mortgage as a tax shelter is a significant advantage for many middle-class individuals whose residences are significant components of their net worth. It also offers incentives to people looking to buy a property by offering a particular tax advantage to the borrower. In the same way, student loan interest serves as a tax shelter. So you might claim that taking on debt has a tax advantage since the interest is tax-deductible.

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Tax Shields for Medical Expenses

Taxpayers who have spent more in medical costs than the standard deduction might itemize to get a higher tax benefit. By filing Schedule A for 2019 and 2020, a person may deduct any amount allocated to medical or dental costs that exceeds 7.5 percent of adjusted gross income.

Tax Shields for Charitable Giving

Charitable donations, like the tax break provided for medical bills, may reduce a taxpayer’s liabilities. To qualify, the individual must itemize his deductions on his tax return. Depending on the circumstances, the deductible amount might be as much as 60% of the taxpayer’s adjusted gross income. Donations must be made to an authorized charity in order to qualify.

Tax Shields for Depreciation

The depreciation deduction enables taxpayers to recoup some losses connected with eligible property depreciation. The deduction may apply to both real assets like automobiles and buildings and intangible assets like computer software and patents. Depreciation must be related with an asset employed in a company or income-generating activity and have a projected lifetime of more than one year to qualify. Other factors, such as the term of ownership of the item and whether the asset was used to develop capital improvements, may impact the potential of depreciation to be deducted.

Read “What is the formula for computing weighted average cost of capital (WACC)?” to learn how tax shelters might effect a company’s balance sheet.

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