The notoriety achieved by tax shelters in recent years, combined with the tax-bracket creep induced by inflation, has heightened public interest in the use of shelters as a financial planning device.
For many people, investment in so-called tax shelters can be a valuable tax planning and investment tool. A shelter, if properly chosen, can provide long-range economic gain while reducing income taxes of the participant. A poorly chosen shelter can be an economic and tax disaster. It is fair to state, however, that the number of shelters with a dubious economic and legal basis probably outnumber those that merit serious consideration. Consequently, in the evaluation of tax shelter investments, the warning "buyer beware" is of added significance.
A tax shelter -- an investment, generally made by participating in a limited partnership designed to produce tax losses to the partners -- can be utilized to offset a taxpayer's other income to reduce taxes.
The losses most highly coveted by taxpayers are those artificial accounting losses that create a tax loss substantialy in excess of economic investment. Thus, a frequently used means of evaluating a tax shelter is the ratio of tax losses produced to cash investment. A shelter that is said to produce losses of 3 to 1 means that the tax write-off for the year in question will equal three times the cash invested in the deal. If an individual is in a 50 percent tax bracket and invests $1,000 in a shelter that produces $3,000 in losses in a year, the tax savings of $1,500 to that individual will exceed the amount of cash investment.
Although individually designed investments, such as the purchase of a condominium for rental purposes, may serve to shelter some income, most investments thought of as tax shelters are either publicly offered through brokerages or privately placed syndicated transactions.
The negative publicity surrounding the use of shelters has tended to obscure the fact that tax shelters are frequently created as a result of a congressionally mandated inducement toward specific types of investment.
For example, the Internal Revenue Code contains a provision that allows a rapid depreciation write-off for rehabilitation expenditures for low income housing. Similarly, rapid depreciation deductions for intangible drilling expenses, have been enacted to encourage private investment in these areas.
At the other end of the spectrum are those types of investments which can best be described as questionable tax schemes. Some examples from recent years include coal syndications with no proven coal reserves, or the creation of grossly inflated deductions by the donation of overvalued art prints to charity.
As to who should invest in tax shelters, no individual should invest in a shelter program unless he or she is in a tax bracket of at least 40 percent to 50 percent, has been in a high bracket for a number of years and possesses a significant amount of other investment assets. Because most shelters, by definition, involve an economic risk, they are not the type of investment that should be selected as soon as someone reaches a high tax bracket or without having made other investments.
Tax-sheltered investments are generally unwise until an individual or famiy has purchased a house that it can easily afford, has some cash reserves and a fair amount of relatively liquid investments.
Once purchased, a tax-sheltered investment is usually difficult, if not impossible, to sell prior to the liquidation of the enterprise. Because these investments are illiquid and long-term, they are not the place to deposit funds needed for such purposes as sending the children to college.
There are several basic factors to evaluate in reviewing any tax shelter proposal:
Is the underlyng property a good economic investment? First and foremost the potential investor should ignore the promised tax benefits and evaluate the investment itself. For example, luxury high-rise apartments in Topeka, Kan., may be a poor investment if there is a glut of luxury dwellings in this particular area. If the underlying investment does not make sense economically, forget the transaction. Never invest solely for the promised tax benefits.
Will the tax benefits actualy be as indicated in the projections? If you cannot evaluate these factors yourself, hire a tax lawyer or accountant who can. The Internal Revenue Service has cracked down on many tax shelter abuses in recent years and has greatly increased its audits of those shelters producing large tax losses.
The existence of an opinion letter from an attorney is no guarantee that the tax benefits will be as promised.
What fees and commissions are being paid to the promoters of the transaction? Tax shelters are frequently structured so that a substantial proportion of the investor's capital contributions will be paid in fees or commissions to the promoters of the transaction. Thus, if the investors are contributing $1 million, but 50 percent of such contributions are being paid in fees and commissions, investors are actually paying $1 million for a $500,000 investment. Beware of excessive fees.
Who gets the ultimate profit from the investment? Many transactions are structured so that most of the ultimate profit will go to the original promoters. Potential investors are well advised to avoid those transactions in which the bulk of the residual profits will not go to the investors.
What is the promoter's track record? The private placement memorandum or offering circular should list the economic results of other deals promoted by the same individuals. Legitimate synidicators generally print an extensive summary of their previous transactions for potential investors to evaluate. If the offering documents do not show an extensive track reocrd, or if they are vague in describing previous results, ask some pointed questions.
In addition to the factors discussed above, the potential investor should always bear in mind one additional rule -- the more exotic the tax benefits that are promised, the more skepticism that you should exhibit.