What is a Tax Shield
A tax shield is a reduction in taxable income for an individual or corporation achieved through claiming allowable deductions such as mortgage interest, medical expenses, charitable donations, amortization and depreciation. These deductions reduce a taxpayer's taxable income for a given year or defer income taxes into future years. Tax shields lower the overall amount of taxes owed by an individual taxpayer or a business.
BREAKING DOWN Tax Shield
The term "tax shield" references a particular deduction's ability to shield portions of the taxpayer’s income from taxation. Tax shields vary from country to country, and their benefits depend on the taxpayer's overall tax rate and cash flows for the given tax year. For example, because interest payments on certain debts are a tax-deductible expense, taking on qualifying debts can act as tax shields. Tax-efficient investment strategies are cornerstones of investing for high net-worth individuals and corporations, whose annual tax bills can be very high.
Calculating the tax shield can be simplified by using this formula:
Tax Shield = Value of Tax Deductible-Expense x Tax Rate
So, for instance, if you have $1,000 in mortgage interest and your tax rate is 24 percent, your tax shield will be $240.
Tax Shields as Incentives
The ability to use a home mortgage as a tax shield is a major benefit for many middle-class people whose homes are major components of their net worth. It also provides incentives to those interested in purchasing a home by providing a specific tax benefit to the borrower. Student loan interest also functions as a tax shield in the same manner. So, you could say that taking on debt has a tax benefit because you can use the interest as a tax-deductible expense.
Tax Shields for Medical Expenses
Taxpayers who have paid more in medical expenses than covered by the standard deduction can choose to itemize in order to gain a larger tax shield. For the 2016 tax year, an individual may deduct any amount attributed to medical or dental expenses that exceeds 10 percent of his adjusted gross income, while a person over the age of 65 may deduct amounts over 7.5 percent of his adjusted gross income.
Tax Shields for Charitable Giving
Similar to the tax shield offered in compensation for medical expenses, charitable giving can also lower a taxpayer’s obligations. In order to qualify, the taxpayer must use itemized deductions on his tax return. The deductible amount may be as high as 50 percent of the taxpayer’s adjusted gross income, depending on the specific circumstances. For donations to qualify, they must be given to an approved organization.
Tax Shields for Depreciation
The depreciation deduction allows taxpayers to recover certain losses associated with the depreciation of qualifying property. The deduction can apply to tangible property, such as vehicles and buildings, as well as to intangible assets, such as computer software and patents. In order to qualify, the depreciation must be associated with an asset used in a business or income-generating activity, and have an expected lifespan of more than one year. Other conditions may affect the ability for depreciation to be deductible, including, but not limited to, the duration of ownership of the asset and whether the asset was used to build capital improvements.
Find out how tax shields can affect a company's balance sheet; read "What is the formula for calculating weighted average cost of capital (WACC)?"