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.
Key Takeaways
- A tax shield allows an individual or corporation to reduce taxable income.
- Tax shields are achieved through claiming allowable deductions, such as mortgage interest, medical expenses, charitable donations, amortization, and depreciation.
- Tax shields lower the amount of taxes an individual or business taxpayer owes.
Understanding a 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%, your tax shield will be $240. You can deduct up to $750,000 of home mortgage interest in 2023. In 2025, this number rises to $1 million.
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. An individual may deduct any amount attributed to medical or dental expenses that exceeds 7.5% of adjusted gross income by filing Schedule A.
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 their tax return. The deductible amount may be as high as 60% 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.
What Is the Formula for Tax Shield?
The formula for tax shield is, Tax Shield = Value of Tax-Deductible Expense x Tax Rate.
Is Tax Shield the Same As Tax Savings?
Tax shields result in tax savings. Tax shields allow for taxpayers to make deductions to their taxable income, which reduces their taxable income. The lower the taxable income, the lower the amount of taxes owed to the government, hence, tax savings for the taxpayer.
What Is a Tax Shield Example?
A common example of a tax shield is mortgage interest. A person buys a house with a mortgage and pays interest on that mortgage. That interest is tax deductible, which is offset against the person’s taxable income. This then reduces their overall tax burden.
The Bottom Line
Tax shields allow taxpayers to reduce the amount of taxes owed by lowering their taxable income. When filing your taxes, ensure you are taking these deductions so that you can save money when tax season arrives.
Related Terms: taxable income, mortgage interest, amortization, depreciation, adjusted gross income, tax savings.
References
- Internal Revenue Service. “Publication 936, Home Mortgage Interest Deduction”, Page 9.
- Tax Foundation. “The Home Mortgage Interest Deduction”.
- Internal Revenue Service. “Topic No. 456, Student Loan Interest Deduction”.
- Internal Revenue Service. “Topic No. 502, Medical and Dental Expenses”.
- Internal Revenue Service. “Publication 526, Charitable Contributions”, Pages 2-3, 14-15.
- Internal Revenue Service. “Publication 946, How To Depreciate Property”, Page 3.
- Internal Revenue Service. “Publication 946, How To Depreciate Property”, Pages 4-5.
- Internal Revenue Service. “Topic No. 505, Interest Expense”.
