What it is:
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 it works (Example):
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 it Matters:
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.