Interest-Bearing Securities Seen as Leading Investment

For investors, the sweeping tax overhaul bill conveys a clear signal: interest-paying investments such as bonds generally will become more attractive, while hard assets such as real estate will become less attractive.

The new tax bill also favors saving over borrowing. Lower personal tax rates will allow savers to keep more interest earnings, while the loss of the deduction for interest on credit card, auto and most other consumer loans will increase the cost of borrowing.

The bill also encourages investors to take as many deductions as possible this year. Many write-offs will not be available next year, and what will be available will be worth less with lower personal tax rates.

The bill also socks wealthier investors more than their less-affluent counterparts. Wealthier taxpayers will receive fewer advantages from some favorite tax dodges, such as limited partnerships, individual retirement accounts, 401(k) company savings plans and vehicles for shifting income to their children. Another favorite, the investment tax credit, will be eliminated entirely, retroactive to last Jan. 1.

But middle-income investors will not emerge totally unscathed; they will see a sharp rise in the tax on capital gains and may suffer most from the loss of deductions on consumer loan interest.

Whether these changes boost savings and investment, as President Reagan and other tax revision proponents hope, is uncertain. Lower tax rates in theory increase incentives for saving, but the tax rate cuts of 1981 have not stopped a decline in the savings rate.

However, what is clear is that investors must increasingly evaluate deals based on their profitability and less on their potential tax write-offs.

“Investment decisions will have to be based on economics,” said William G. Brennan, a tax accountant and publisher of a Valley Forge, Pa., tax shelter newsletter.

Here is a look at how the new tax bill will affect various areas of investment and financial planning:

YEAR-END TAX PLANNING

Taxpayers are being urged to take as many deductions as possible this year. Lower personal tax rates next year will make deductions worth less in 1987.

Taxpayers thus should consider moving charitable contributions planned for next year into this year, advisers said. They should also consider buying big-ticket items, such as cars or furniture, before the end of the year to take advantage of the sales tax deduction, which will not be available next year under the tax overhaul plan.

Taxpayers also should consider prepaying this year union dues and other employee business expenses, fees for the preparation of tax returns and subscriptions for job-related publications. Those expenses are fully deductible this year, but next year under the new bill they can be written off only to the extent they exceed 2% of a taxpayer’s adjusted gross income.

STOCKS

The impact of the new tax plan on stocks is generally mixed, financial experts said.

The provision to tax long-term capital gains with a top rate of 28% next year and 33% in 1988 and beyond could discourage investors from holding stocks for long periods of time, some said. Currently, gains on stocks or other capital held longer than six months are taxed at a top rate of 20%.

Middle-income taxpayers are expected to see sharper rises in capital gains taxes than higher-income taxpayers, because some middle-income people now enjoying capital gains rates lower than 20% will have to pay the new maximum rates, the same as on ordinary income. By contrast, capital gains rates for the wealthiest taxpayers will only go from 20% to the maximum rate of 28%.

The rise in the capital gains tax, which takes effect Jan. 1 of next year, also could lead to some year-end selling of stocks by investors wanting gains on their stocks taxed at the current lower rates.

But in the long run, the higher capital gains tax will not discourage people from buying stocks, said David M. Blitzer, chief economist for the investment firm of Standard & Poor’s. “When people buy stocks, they are hoping for enough appreciation to pay the tax man,” he said.

And on the positive side, the lower personal tax rates under the new tax plan will actually result in a tax cut for those owning stocks for short periods of time. Under current law, short-term capital gains are taxed as high as 50%.

“So you’re going to see more trading rather than less, and that means more interest in the stock market,” said John D. Connolly, chief investment strategist for the brokerage firm of Dean Witter Reynolds.

BONDS

Bonds are clear winners under the new tax bill, experts said.

First, by taxing long-term capital gains as ordinary income, the new tax bill will treat interest earnings from bonds the same as capital gains from stocks, thus making bonds more competitive with stocks.

Corporate, Treasury and other taxable bonds will benefit because lower individual tax rates will increase their after-tax returns.

But tax-exempt municipals also are expected to remain attractive, even though lower personal tax rates in effect cut their after-tax yield. Municipals will remain attractive in part because they will be one of few remaining tax-favored investments, which will be of particular importance to investors in California and other states with high state income taxes.

Also, yields on municipals eventually will be driven up to make them competitive with corporate bonds, Treasury bonds and other securities, said William H. Gross, managing director of Pacific Investment Management Co. of Newport Beach. The downside is that the price of bonds already traded would drop because their tax-exempt status would be less valuable to investors taxed at lower rates.

REAL ESTATE

The new tax bill retains the deduction for mortgage interest on first and second homes, making that write-off one of the few remaining tax shelters. However, lower personal tax rates will reduce the value of the deduction, in effect raising the cost of home ownership.

Other real estate investments, favored under current tax laws, are clearly less advantageous under the new tax bill.

By eliminating the investment tax credit and making real estate depreciation schedules less generous, the tax bill reduces the attractiveness of buying apartments and other rental housing for tax write-off purposes.

“Real estate will have the same status with other investments,” said James C. Godbout, tax partner with the accounting firm of Ernst & Whinney.

The tax bill also is expected to hurt real estate limited partnerships, one of the most popular tax shelters. It will provide further impetus for a recent trend in which partnerships have stressed income over write-offs.

The provision that most hurts shelters is one that limits investors’ ability to deduct losses from so-called “passive” investments--any trade or business that the investor is not actively managing, such as limited partnerships. Such losses can be deducted only against income from other passive investments, not against income from wages, stocks or other investments, which is possible under current law.

The rule will apply to all new shelters but also could hurt investments in existing shelters. However, a provision in the tax-overhaul bill phasing in changes over five years could ease the impact.

RETIREMENT PLANS

The new tax bill reduces the attractiveness of IRAs and 401(k) plans.

Individuals not covered by company pensions will still get full $2,000 deductions for contributions to IRAs, regardless of their incomes. But couples filing joint returns (where one or both spouses are covered by pensions) may take the full deduction only if their adjusted gross income is below $40,000. Couples between $40,000 and $50,000 may get partial deductions but above $50,000 no deduction will be allowed. For single filers, full deductions will be phased out beginning at $25,000, with total phase-out at $35,000.

However, as many as three-fourths of all IRA users still will qualify for full or partial deductions under this plan, tax experts said. And earnings on IRAs for all taxpayers will continue to accumulate tax-free until withdrawn, “making IRAs still attractive” for many investors, said Stuart J. Brahs, executive director of the Assn. of Private Pension and Welfare Plans.