The $16 billion tax shelter industry, once dominated by aggressive promoters offering more sizzle than steak, is being driven by economic and regulatory forces to clean up its act. This transformation is occurring at a time when the middle class, despite recent tax cuts and uncertainty about future changes, is investing in shelters more heavily than ever.
Picking a shelter was once almost as simple as deciding how big a deduction to seek. "People still come to me this time of year and say 'I need a 2-to-1 write-off,' " says H. Lynn Hopewell Jr., a Falls Church financial planner and tax shelter expert. They quickly learn that the rules of the game have changed.
For example, many end-of-year shelters used to offer write-offs as high as 8 to 1 by helping investors borrow heavily to prepay deductible expenses for goods that would be used late in the following year.
For example, an investor might buy expensive oil-drilling equipment in December and claim tax benefits that year, even though the gearactually would not be in operation until nearly a year later.
Under the 1984 tax law, however, most last-minute deductions are available only if the activity financed by the shelter begins or, in some cases, is actually completed, within 90 days of the beginning of the next year.
Yet these and other changes -- such as a recent Internal Revenue Service crusade against "abusive" shelters -- ultimately may prove beneficial to the average investor. Hopewell believes the new rules "will take the wind out of the sails of the programs that just manipulate the numbers to produce high write-offs." He said the result is that "the economics of the shelter become much more visible." That is, it will be easier for investors to gauge whether the program will offer profits down the road in addition to tax benefits at the outset.
Lower inflation also has contributed to this result. In real estate, for example, high inflation during the 1970s made it easy for sponsors of tax shelters to snap up properties at premium prices that could not be justified by anticipated lease income. Many also rewarded themselves handsomely with fees that bore little relationship to their investment performance.
Investors would ignore those shortcomings because the tax benefits -- their main objective -- were substantial. Also, they reasonably could assume that inflation in the real estate market would allow them to break even -- if not actually come out ahead -- when the property was sold.
Despite the broad range of shelters on the market today, Hopewell finds that most of his clients are interested in "very sober, plain vanilla" real estate partnerships, offering total write-offs generally not exceeding 1 to 1 during the entire "pay-in" period.
His clients reflect the nation as a whole, which invested $4 billion in "public" real estate programs registered with Securities and Exchange Commission during the first nine months of the year, according to Robert Stanger & Co., a Shrewsbury, N.J., firm that monitors limited partnerships. The $4 billion figure contrasts with $1.3 billion in oil and gas programs, $268 million in equipment-leasing partnerships and another $325 million in all other categories.
Those figures include money invested in partnerships whose goal is to generate more income than tax benefits, a rapidly growing sector of the public partnership market.
During the same period last year, investors put $3.2 billion in public real estate programs and $2.3 billion in oil and gas, $270 million in equipment leasing and $352 million in other shelters.
The public programs represent about 60 percent of the total market, according to the Stanger company, with smaller, more aggressive "private" deals aimed at wealthier investors making up the balance. Statistics on private programs are sketchy.
Why is real estate so popular? "People understand it better," Hopewell said. "It has a track record. And you can go through the door and look at it."
Real estate also offers the widest range of investment programs. Some long-term appreciation programs can tie investors down for 20 years or longer. Others, such as renovation projects, are designed to liquidate within three years.
Some pay all cash for properties to give investors maximum protection in bad markets, although less than spectacular profits. Others are "highly leveraged" (borrow heavily), maximize tax benefits and offer the hope of substantial profits. The price is higher risk. Still others fall in between.
Large public real estate programs, such as those sponsored by Balcor/American Express, require only one initial cash contribution. Minimum investments are frequently as little as $2,000. First-year write-offs typically do not exceed 50 percent of the cash invested, although subsequent deductions often bring the total write-off to 100 or 110 percent of the initial amount invested.
A relatively aggressive private real estate program sponsored by the New York-based Patrician Group, in contrast, is trying to raise $6.8 million in cash to purchase two shopping malls in Colorado and Utah for $15.8 million. The difference would be borrowed.
Investors who purchase one-half a unit would pay in $155,750 over seven years, and take a projected cumulative write-off of 2.3 to 1 during that period. During "We stress to our clients the importance of investing those savings instead of using them for something like a vacation. That's what increases your net worth." Yolanda Wolf the first full year, investors would put down $48,500 cash and claim estimated losses of $108,760, according to a brochure distributed to brokers.
Purchasers would not begin receiving substantial returns until 1995, although their projected tax savings during the earlier years would give them a "positive cash flow."
The sponsor's description of the deal, given to brokers, states that a "high degree of risk" is involved.
Although intense competition among investors and overbuilding in some markets has tarnished real estate's image as a foolproof investment, investors remain confident about its long-range potential.
They are far less sanguine, however, about the oil and gas industry, in which investment in public programs has dropped by 47 percent since last year. "They're responding to news about the Organization of Petroleum Exporting Countries problems and falling oil prices," said Donald Korn, editor of Tax Shelter Insider, an industry newsletter.
Another factor was the collapse early this year of Petro-Lewis Corp., a giant Denver firm that sponsored dozens of income programs.
Some advisers believe that the public's fleeing from oil and gas programs -- and the depressive effect it has had on drilling costs -- indicate that now is the time to rejoin that field. For drilling programs, which offer the most substantial tax benefits in that industry (typically a 70 to 100 percent write-off in the first year), today's price of petroleum should not be an investor's top concern, according to Korn.
"The real question is whether they're going to find oil," he said. "If they can find it and drill it for between $8 and $10 a barrel, it doesn't matter whether OPEC's charging $26 or $28."
How can investors choose drilling programs that will produce? "All you can do is look at their past," said Korn, who cautions listeners that "that hardly offers a guarantee."
The third-most-popular tax shelter variety -- the equipment-leasing partnership -- is the province of the sophisticated investor. These programs typically borrow as much or more than they raise directly from investors to buy the equipment they lease. This lets the partnership spread more investment tax credits and depreciation deductions among a smaller pool of investors.
Many such programs buy and lease computers and related equipment, whose resale value at the end of the lease term is often negligible due to technological obsolescence. Unlike real estate programs, equipment leasing offers no hope of making a profit by selling the property later.
Taxes begin coming due in future years when write-offs no longer offset lease income. Participants who have failed to put away their tax savings during the early years can find themselves in a cash bind, warned Yolanda Wolf, an investment broker with Kidder, Peabody & Co. in Washington. "We stress to our clients the importance of investing those savings instead of using them for something like a vacation," she said. "That's what increases your net worth."
The principle applies to all shelters -- including many in agriculture -- whose major purpose is to defer taxes rather than offer a combination of tax benefits and the hope of long-term gains.
Investment advisers also try to make sure their clients' income justifies investing in a shelter. Although an individual's gross income might indicate a high tax bracket, the key is the taxpayer's bracket after claiming all normal itemized deductions. "A couple might require around $85,000 of combined taxable income before needing a deep shelter," Wolf said. That could mean a gross income exceeding $100,000. Taxable income over $85,000 is taxed at a 45 percent rate. For an individual, the figure is closer to $42,000.
When investors find they do indeed need shelter and have traversed the mind-numbing array of choices, they still have to choose among sponsors. The established syndication firms, such as JMB Realty, Integrated Resources, Balcor, Winthrop Realty and Consolidated Capital, have been joined in recent years by most of the major stock brokerage and insurance firms.
Although most brokerage firms traditionally had represented the independent tax shelter sponsors, they only recently have begun selling their own programs. And insurance companies have entered the business to make money and to sustain their agents -- whose ranks have dwindled since the decline in sales of lucrative whole life policies.
When choosing among these sponsors, investors probablywould not have to consider whether the tax shelter is a potential target of theIRS crackdownon abuses. That's because public programs are the most conservative on the market.
Congress gave the IRS new powers in 1982 to seek injunctions against scam shelters and obtain lists of investors. The idea was to prevent taxpayers from taking deductions in the first place instead of fighting them in court after the fact. And new rules enacted this year require almost all shelters to register with the IRS, whether or not they appear abusive.
The most aggressive private shelter programs -- those limited to 35 investors (excluding millionaires) -- require the greatest scrutiny. To spot an "abusive" shelter, Korn suggests prospective investors ask themselves: "Does the plan make any sense?
"If you're buying a windmill that might cost $10,000, and you're paying $100,000, obviously something's wrong."
In less-clear-cut situations, however, advisers suggest professional advice is the only answer -- particularly when the money involved is substantial.
Ironically, they find that, when it comes to tax shelters, people often spend money more impulsively than when they make mundane purchases.
"A couple came to me asking about a Jiffy Lube franchise program," Hopewell recalled. "They wanted to put all their savings into it.
"The program wasn't bad, but it involved risk, so I urged them not to sink everything in." His advice was ignored. "People seem to get caught up emotionally in these things," he said.