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.