Although it sounds like a specific place, a tax shelter is any investment strategy that enables you to legally decrease or avoid taxation. Actual tax shelter investments sometimes require a large investment with a degree of risk. The goal of many shelters is to create offsetting losses to other taxable income.

Tax sheltering allows you to either pay your taxes at a later time (tax-deferral), or to minimize your tax liability (tax avoidance). It is important to note that tax avoidance is not the same thing as tax evasion, which is illegal. Tax evasion is the failure to pay or report taxes, or to willfully report them incorrectly.

One way to reduce the amount of taxes you pay on your investments is to receive a tax credit. A tax credit is a dollar-for-dollar reduction on the tax you owe. For example, a tax credit of $1,000 reduces the amount of taxes you owe by $1,000. This is not the same as a tax deduction, which simply reduces taxable income. The value of the deduction, therefore, depends on your tax bracket. In a 28 percent tax bracket, a $1,000 deduction reduces your taxes by only $280. Dollar for dollar, a tax credit is worth more than a tax deduction.

In order to take advantage of tax sheltering, you'll need to be able to differentiate between two types of taxable income. Passive activity income is derived from a trade or business activity in which you didn't "materially participate" during the tax year. You are deemed to have "materially participated" by qualifying under one of seven IRS tests, each of which requires actual, continuous substantial involvement in the business activity (for example, you spent at least 100 hours during the year in the activity, and nobody else spent any more time than you did). Generally, you can only deduct passive activity losses from passive activity income.

In most common situations, income from real estate rental is an example of passive income. There is a special break, however, allowing a passive loss from rental real estate to be deducted from non-passive income, such as wages, if the taxpayer actively participates and certain other requirements are met. This passive loss deduction is limited to $25,000 but is reduced by 50 percent of the amount of the taxpayer's adjusted gross income that exceeds $100,000.

Active income, on the other hand, is income from wages, tips, salaries, commissions, and a trade or business in which you materially participate.

So, what methods can you use to legally reduce taxes? Here are some of the most common:

• Lower your current taxable income — Placing your money in certain investments is one way to lower your taxable income.
• Lower the tax rate of certain income — For example, hold onto an investment long enough to be taxed at long-term rather than short-term capital gains rates.
• Increase your itemized deductions — Sometimes, you can combine deductions in one year to gain a higher benefit.
• Defer income to years when you expect to be in a lower tax bracket.

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