What is a Loophole?

A loophole is an exception that allows a system to be circumvented or avoided. It usually refers to legal, taxation, or security strategies that are exploited for personal gain.

How Does a Loophole Work?

Loopholes are failures of a system to account for all conditions, variables, or exceptions. To illustrate a legal loophole, consider a local development law that requires even an unoccupied building to pay real estate taxes so long as it receives a certificate of completion. In order to avoid paying taxes, a builder may exploit this loophole and choose not to 'complete' the building.

An example of a tax loophole is the tax break for small businesses who invest in 'heavy vehicles'. The tax break applies if the vehicle is used at least 50% of the time for the business. Business owners may exploit this loophole by upgrading their own vehicles to SUVs, which are considered 'heavy' under the tax law, and thereby gain a personal financial advantage.

In most instances, loopholes that lead to excessive abuse are corrected by subsequent regulations and laws.

Why Does a Loophole Matter?

While loopholes may save money or allow a purchase that would otherwise not be economical, the use of loopholes is considered questionable. Exploiting loopholes may lead to intensive scrutiny and audits, or even just a feeling of bad faith. For example, a tax payer should be aware when a tax consultant advises of specific tax advantage of whether the advantage is claimed on the basis of an allowable deduction or a loophole.

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Paul Tracy
Paul Tracy

Paul has been a respected figure in the financial markets for more than two decades. Prior to starting InvestingAnswers, Paul founded and managed one of the most influential investment research firms in America, with more than 3 million monthly readers.

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