YOUR TAXES : PART TWO: REAL ESTATE : How the old shelters worked

The classic old-style shelters took advantage of several elements in the tax laws, but essentially they relied on a high degree of debt financing (or leverage), accelerated depreciation and the conversion of ordinary income into long-term capital gains.

Say, for example, you agreed to invest $10,000 a year for five years in a real estate limited partnership that planned to build a new office building. The deal’s promoter--the general partner--took your $10,000 and went out and borrowed an additional $40,000, using your pledge of future payments as security for the loan. He then used that $50,000 as a 20% down payment on a construction loan for the office building.

Thus, with an investment of only $10,000, you would own a $250,000 share in the office building project (minus the promoter’s fees, which could be substantial). You would also have the right to deduct a great many expenses from your taxable income--especially mortgage interest, depreciation and some of the promoter’s fees. (A syndicator’s marketing expenses were not deductible by the limited partners.)

A deal such as this had heavy up-front costs, and substantial revenue may not begin to appear for several years. It may take a couple of years to construct the office building; it may take another year or two to lease out the space. But during this whole time, you have paper losses to write off.

In fact, if the writeoffs are large enough, you may not care if the project ever turns a profit. You’ve already made a healthy return on your investment through tax savings. What does it matter that your building was erected in the glutted Houston market? Who cares that half of its space won’t get leased until the next decade?

In most cases, of course, the building eventually fills up with tenants; the accelerated depreciation schedule begins to offer smaller and smaller deductions; the project starts to produce more revenue than expenses. Since you don’t want to pay ordinary income tax on these expected profits, it’s time to sell the building. The final tax benefit of this deal was that your profit from the sale was taxed as a long-term capital gain--with a maximum rate of only 20%--not as ordinary income, with a rate of up to 50%.