Where have all the tax shelters gone?
A lot of them--although by no means all--have gone out the window as Congress has sought to fashion a tax law that is fairer and encourages more rational investment decisions.
The new tax law has clamped down hard on real estate syndications, farm investment programs, movie financing projects and other deals that allowed the wealthy to slash their tax bills.
"What tax reform says is, 'Let's remove the code from between the investor and the market,' " Sen. Bill Bradley (D-N.J.), a major force behind tax reform, said in a recent speech. People should "invest money to make money, not to lose money for tax purposes."
Tax shelter promoters are already adjusting to the new environment--quickly moving away from deals that in their most extreme form provided paper losses, and thus tax deductions, worth several times an investor's actual cash outlay.
Promoters are shifting to what they like to call "economic deals"--those that have more going for them than some hefty tax breaks.
"We've essentially given up that (tax shelter) side of the business," said C. Richard Hansen Jr., president of marketing for August Financial Corp., the Long Beach-based real estate syndication unit of Glenfed Inc. In the past, about 20% to 25% of August Financial's syndication deals were tax-oriented--offering writeoffs as high as 2.8 times an investor's cash outlay--but now the company is concentrating exclusively on "income-oriented" packages that generate roughly a 7% tax-free return on investment.
Why the big change in the tax shelter business? A big change in the rules. After a phase-in period, investors will no longer be able to use losses in most tax shelters to offset ordinary income; the losses can only be used to offset income from similar "passive" investments. Under the new law, virtually all forms of real estate investing, as well as other tax shelter deals, have been defined as "passive" activities.
(According to "The Arthur Young Tax Guide," passive investments include "all rental activities, all limited partnerships and those other businesses in which the taxpayer is not involved in the operations on a regular, continuous and substantial basis." Earnings from savings accounts and from investments in stocks, bonds and mutual funds are considered portfolio income, not passive income.
New limits on the deductibility of passive investment losses have put a damper on shelters oriented toward creating tax-deductible losses. Privately placed real estate limited partnerships, which typically have that orientation, may raise only $1 billion this year, estimates Robert A. Stanger & Co., a research firm in Shrewsbury, N.J. That is far below the $2.8 billion raised in 1986. Due to previous pressures from the Internal Revenue Service, such partnerships had already lost standing. In 1984, they collected more than $5.3 billion.
By contrast, income-oriented public limited partnerships, having already raised more than $6 billion last year, compared to less than $1 billion in 1982, are expected to keep up their torrid pace of growth.
The new law does offer a few bright spots, however. For those who invested in passive activities before the tax reform bill was signed into law on Oct. 23, 1986, their losses will remain partially deductible against ordinary income for a four-year phase-in period: 65% will be deductible in 1987, 40% in 1988, 20% in 1989 and 10% in 1990.
If a taxpayer doesn't have enough passive income to match against his passive losses, the unused losses may be carried forward and applied against passive income in later years, including any gain on the sale of the property.
One traditional tax shelter remains quite attractive under tax reform. For investors willing to put up with a few headaches, experts say the best real estate tax shelter now available--besides owning your own home--is rental property.
If you have at least a 10% stake in the property, and if you have less than $100,000 in adjusted gross income--calculated without an IRA deduction, Social Security income or the deductible portion of passive activity losses--you can deduct up to $25,000 in losses from rental activities against ordinary income, provided you're actively involved in the management of the rental property. While you may hire a professional to manage the property, you must actively participate in major decisions such as approving new tenants, setting lease terms and approving new capital expenditures and repairs.
For every $2 that your adjusted gross income exceeds $100,000, the maximum deduction for rental losses is reduced by $1. Thus, if your adjusted gross income is $120,000, the maximum deduction is lowered by $10,000 to $15,000, and the deduction is eliminated when your adjusted gross income reaches $150,000.
Because investing in "actively managed" rental properties partially gets around the passive activity rules, "every individual who qualifies should be doing that," said Stan Ross, a partner with the Kenneth Leventhal & Co. accounting firm in Los Angeles, "especially in 1987 because of the higher tax rate." (The top federal tax rate in 1987 is 38.5%, compared to 28% for most taxpayers in later years.) And, Ross noted, "with state tax, you're back up to nearly 50%."
Many investors, however, won't want to be bothered with buying a few houses or apartment units and renting them out. Many will turn instead to income-oriented limited partnerships.
So how do you know an "economic deal" when you see one? And do they make sense for you?
In an "economic deal," said Fuhrman Nettles, vice president of Robert A. Stanger & Co., the price to the investors is close to what the promoter paid for the property--that is, initial fees are relatively small. Also, borrowing by the partnership should be low to moderate. (Many of the new deals make all-cash investments.) And the partnership should invest in fully leased properties that produce rental income immediately rather than in new construction projects with heavy up-front losses.
Rental income normally will exceed operating expenses and debt payments, creating a positive cash flow for the investors from the start. (In some deals, depreciation expenses may provide a tax shelter for all of the investor's annual return, which typically ranges from 6% to 9%; other deals generate unsheltered passive income that can be matched against losses from previous partnership investments.)
For a taxpayer with sizable passive activity losses (PALs) from existing partnerships, the idea of investing in passive income generators (PIGs) has an obvious appeal: The PAL won't be wasted and the PIG will be sheltered. "Finding a PIG for your PAL" has emerged as the industry's latest marketing buzz phrase.
But this strategy may not be as workable as it might seem.
"The investment required is too great," notes Creighton Lacey-Baker, executive vice president of Integrated Resources Inc., a major packager of real estate syndication deals. "If you have $100,000 in (passive) losses, the amount you need to invest to generate $100,000 in passive income might be, say, $1 million. Most people don't have that kind of money to invest.
"I think a lot of people will be buying passive income deals without realizing that they won't be able to offset very much of their earlier losses," he added.
In these income-oriented partnerships, like any other real estate investing, "you've got to be careful about location," Lacey-Baker said. "Some cities are so overbuilt that it will take 10 years to relieve the situation."
And the quality of the properties is important too: Lacey-Baker believes that investors should stick with high-quality buildings in prime locations. "You'll pay a premium" for such deals, he said, but "there's an institutional demand (from pension funds and foreign investors) for properties in these areas," such as Midtown Manhattan, Washington and downtown Los Angeles. This demand ensures that the partnership will easily be able to sell the properties several years down the road, perhaps for a sizable gain.
Because income-oriented deals can't sustain the initial losses associated with new construction and still generate a positive cash flow, many industry observers fear that the new tax law may create a shortage of capital for such projects.
"The law most severely affects new construction," Nettles said. But a decline in new construction could be healthy for real estate investments in the long run, many experts believe, because it will help to eliminate the current glut of office space in many cities. In addition, "slower depreciation schedules will result in higher rents on properties," which will translate into higher real estate values, Nettles said.
But not everyone believes the new income-oriented partnerships are such a good deal.
"They're nonsense," said Charles J. Givens, a Florida investment adviser and businessman. "With a 10.5% to 12% guaranteed return and a share of the profits (when the property is sold), that would be attractive. But unless you can get a higher return than a tax-free municipal bond, it's not worth the higher risk."
All-cash deals are particularly unattractive, Givens said, because without leverage, the gain from the property's appreciation when it is sold won't be that significant. "Tie up other people's money long term, not your own," he urged.