Senate Bill Aims Wrecking Ball at Tax Shelters

To investment consultant Scott G. Miller, the strongest arguments for tax reform are just outside his office, rising from the San Diego hills that roll to the Pacific Ocean a few miles west.

“I can look out my window and see 15 new office buildings, all of them half-empty,” Miller fumed last week. “Why are they building them? Because people give them the money.”

And why do people pour money into office buildings no one wants to occupy? Such investors are among millions of well-heeled Americans sinking billions of dollars into tax shelters--offices, oil wells, even railroad cars--that can spin off deductible “paper losses” totaling two or more times the money invested.

Investment Rules Eased

The shelters soared as high as the skyscrapers they financed after the Reagan Administration’s 1981 tax revisions eased investment rules. Real estate partnerships alone claimed an astounding $14.9 billion in net losses on 1983 tax returns--enough to offset $6.9 billion in taxes for investors in the 50% bracket, although the tax loss to the Treasury was probably somewhat smaller.

Oil and gas ventures were the other huge category of shelters, claiming $3.5 billion in red ink. But wherever there is money to be lost, a tax shelter can usually be found.

“A couple of years ago, it seemed like every dentist in Missouri owned a piece of a barge,” Sen. John C. Danforth (R-Mo.) said during the Senate Finance Committee’s recent tax hearings.

What the committee proposes to do about it has loosed panic among sellers and users of shelters. The Senate tax-overhaul bill, scheduled for a June vote, would demolish most shelters--wiping out many deductions, diluting others, capturing $50 billion in new tax revenues by 1991 and--its backers say--restoring some long-lost equity to tax tables.

If the combination is almost undeniably appealing to politicians, the shelter industry is unpersuaded. It contends that the tax bill’s attack on shelters will wreck an incentive system that has financed not just some empty office buildings but hundreds of thousands of low-income apartments, needed domestic oil wells and other productive investments.

The industry’s portrait of the post-reform economy is decidedly dour: a shortage of subsidized housing, higher rents, a real-estate depression, rising dependence on foreign oil, widespread unemployment and financial hardship.

“This could be a trigger to a severe economic decline in the United States,” said Fuhrman Nettles, vice president of Robert A. Stanger & Co., a New Jersey investment advisory firm. “You just can’t pull something like this out of the economy all at once.”

Breach of Promise?

Others call the Senate proposal a breach of the government’s promise of tax deductions that enticed thousands of shelter investors after the 1981 tax act. The Senate proposal would phase out most deductions over a five-year period, but some complain that that is not long enough to allow recent investors to extract the tax benefits they had anticipated.

But tax reformers are skeptical of those claims. Any depression, joblessness and other economic hardship stemming from the Senate bill, they say, will occur mostly among tax-shelter marketers whose livelihood is endangered by the legislation.

“They’ve dropped an A-bomb on the financial planning community,” Miller said.

Squarely in the bombsight, as outlined in May hearings on the tax bill, are the tax shelters marketed to a relative handful of wealthy Americans who have $50,000 or more to place in tax-avoiding investments each year.

A common vehicle for such investments is the limited partnership, in which the investors have limited legal liability and are not involved in day-to-day management of the project. A 1983 IRS survey of the nation’s 1.5 million limited partnerships found that roughly half either broke even or reported losses, with a net loss for all partnerships of $2.6 billion that year.

Investors Claim Losses

Some of those losses exist on paper only. Sound tax shelters actually produce bankable money; investors claim losses on their tax forms by deducting interest payments on borrowed money, operating expenses and accelerated depreciation, among other gambits.

Armed with a good tax lawyer, a shelter can parlay a $50,000 investment into $100,000 or more in deductions. If the shelter is later sold, capital gains rules exempt 60% of the sale profits from taxation.

The Senate bill would put the wrecking ball to shelters at their foundation--their tax-deductibility--by disallowing deductions for losses except to offset income, present or future, from similar investments. That change alone would unroof most shelters by ending their ability to shield wages and other ordinary income from taxation.

Other proposed changes--abolishing the interest deduction, stretching real estate depreciation from the current 19 to 31.5 years, and repealing both the capital gains tax and its 60% exclusion--would complete the demolition.

And, if that were not enough, the Senate bill’s proposed easing of the top tax rate from 50% to 27% would sharply reduce the allure of shelters by diluting the tax savings from each dollar deducted.

Reduced Tax Rates

Economists, tax reformers and the middle and lower classes would be unlikely to mourn the shelters’ demise. The anticipated $50 billion netted by such an action would finance reduced tax rates and allow the poorest 6 million taxpayers to be dropped from the rolls completely.

It also would encourage investors to look for economically sound projects instead of tax dodges. Critics contend that the 1981 tax law made it profitable to pick up real estate and other tax-shielding investments, quickly extract their depreciation and interest deductions and then dump the property before maintenance costs begin to rise.

Moreover, they say, the tax distortions of shelters have financed gluts in offices, hotels and other big write-off fields. Limited partnership investments in real estate mushroomed from a paltry $87 million in 1975 to $12.7 billion a decade later, the Stanger firm says. The nation today has enough empty office buildings to last four to seven years, according to the investment firm of Salomon Bros.

The notion that tax shelters contribute to office and hotel gluts and that their abolition will ease the surplus “has some truth,” said Alan Parisse, senior vice president of Consolidated Capital Equities Corp., a shelter packager in Emeryville, Calif. “But it’s not the whole truth.”

The whole truth, he said, is that Congress created deductions in 1981 to divert tax dollars into chosen economic areas--machinery and construction, among them--just as it spurs charity by making donations tax deductible.

“And now that the recovery has happened, the same President and Senate are saying: ‘We’re going to take it away from you,’ ” he said. “It’s unfair.”

What most angers Parisse and other shelter experts is not the probable loss of write-offs, but the issue of “retroactivity.” Although the shelter-curbing clauses in the Senate bill would take effect next Jan. 1, their impact would be felt by large numbers of investors who signed up for “programs” requiring investments over five or more years.

Investors who signed up for such programs two or three years ago could face a triple whammy from the tax bill, the shelter marketers say.

Those investors would be legally obligated to make regular payments on a shelter investment but would lose the tax benefits that may have made it economically viable to begin with.

Finally, once stripped of its deductions, the shelter may lose much of its resale value. If the investment was financed largely by bank loans--say, a big mortgage that exceeds a building’s actual value--investors could lose the money they ponied up as equity.

The pain would be especially acute for big real estate shelters, syndicators say. Some experts say the market value of apartment buildings is already dropping in anticipation of Senate passage of an anti-shelter bill, and forecasts of a 20% to 25% drop in the prices of overbuilt commercial and office real estate are not uncommon.

Tax Revenue Effect

Syndicators and investment advisers point out that lower real estate prices will translate into lower tax revenues when properties are later sold. Nettles pegs the loss of capital-gains revenues at a maximum $2 billion over five years.

The gloomiest warn that an end to tax benefits in the real estate business will plunge investors into a $15-billion bath of red ink, and that the construction and building-materials industries will quickly follow.

The construction industry, which has been generally supportive of the Senate tax bill, so far does not share the gloomy view. Nor do most shelter experts, although many claim to see other downsides.

“Long term, I think this’ll be good for prices,” Parisse said. “Development will be greatly restricted, buildings will start filling up and rents will start moving through the roof.

“But the renters will pay for this bill. They’ll save 80 bucks on their taxes and pay an extra 35 bucks a month in rent.”

Sale Price Cut

Miller and other critics doubt it. On the contrary, they say, write-offs and syndication fees for shelters have so pumped up the resale value of buildings that a tax overhaul can only cut sale prices and lower the amount of rental income needed to turn a profit.

Meanwhile, accountants are sharpening their pencils, looking for prospective new loopholes that can keep tax shelter partnerships humming.

One idea is to make investors general partners in tax shelters, instead of limited partners--a move that would take them out of the “passive investor” category now targeted by the tax bill, but also would expose them to massive liability for lawsuits, cost overruns and the like.

The answer to that worry? Simple, the analysts say. Sign up an insurance company as a limited partner and buy some liability insurance--a deductible business expense, of course.

RACKING UP THE DEDUCTIONS

Limited partnerships in oil and gas and real estate ventures compose the bulk of tax shelter partnerships whose popularity has soared since passage of 1981 tax legislation. Through depreciation, interest, and other deductions, reported losses grew. Latest figures available are 1983.

In Billions Total investment in oil/gas 1981: $7.47 and real estate 1982: $8.12 limited partnerships 1983: $12.43 Gross income 1981: $43.1 from the 1982: $49.6 limited partnerships 1983: $56.8 Total deductions 1981: $60.4 on limited partnerships 1982: $68.4 income 1983: $75.2 Net Losses available to 1981: $17.3 partners for sheltering 1982: $18.8 other income 1983: $18.4

SOURCES: IRS and Robert A. Stanger & Co.