If everything goes well, there are substantial tax advantages for high-in-come individuals who are partners in owning a building.
Washington tax lawyers explained that in the early years of a classic real estate limited partnership, if everything is properly organized and the project is efficiently operated:
An investor risks nothing but the money he puts in.
The project will produce more money (rent) than the building will cost to operate. In other words, it will cost to operate. In other words, it will produce "cash flow."
Tax deductions - primarily in the form of allowances for deterioration of the building (depreciation) and for interest on the mortgages - will total more than the amount of cash produced by the building.
Thus the building's owners have the money from the building and do not have to pay taxes on all of it. There is a bonus: If there are excess tax deducations - the total of depreciation and interest allowances that exceed the project's income - they can be passed through the partnership to lower the through the partnership to lower the tax bills of individual partners on income they earn from other sources.
In 1975, the congressional Joint Committee on Internal Revenue Taxation released a study of selected income tax returns. In three real estate partnerships, the committee found, tax losses averaging $1.42 were passed to the investors for each $1 invested.
But such an idyllic result is reached only after some peril, and can only last so long, according to tax experts.
Real estate, despite what has been said, is inherently risky several experts agreed. The fact that it is so risky is one of the reasons it was the only classic tax shelter to survive the so-called Tax Reform Act of 1976 virtually intact, acording to congressional sources. Without tax incentives, the real estate lobby suggested, it would very difficult to raised venture income for an already depressed industry.
The primary risk is the simple law of supply and demand. There may be a need for a building when it is planned, but by the time land is aquired, financing arranged, permits obtained and construction completed, months have passed and the need might have disappeared.
In exchange for taking that risk, the greatest tax advantage in real estate, is normally gained during the construction period. But basic advantages the owners of an existing building, particularly if they can buy it with little money down. The higher, the bigger the tax shelter.
However, there is a mathematically determinable point where the building ceases to be a shelter and starts to become a liability becauses the rate of depreciation has declined and the mortagage payment consists of more principal than interest. The building still produces money in the form of rent, and that money is still taxable, but the deductions are gone.
It may be difficult to sell a share of a partnership that owns such a building. Further, the moment the building is sold there can be a huge tax liability on the profits of the sale. In such situations, the clever investor can control the timing of the sale as well as finding another shelter to cover his taxes. The new owner has the same tax advantages - depreciation and interest - that the seller did.
If the building goes to bankruptcy, the investor may have taxable gains, but no control over the timing of the sale and no cash.
"The bottom line advice we give when we are asked to review a deal for an investor," one tax adviser said, "is to ask the question: is this a good economic investment over the long haul without regard to tax benefits?"