If you're one of the tens of thousands of small-scale investors in real estate partnerships around the country, the Internal Revenue Service has a blunt, ominous message for you:
We're about to take a tough new stance on tax-shelter-oriented real estate partnerships. We're about to clamp down hard on some techniques that are widely used in real estate investments -- particularly those that inflate interest deductions to create big, attractive write-offs in the early years.
We're also going to use our new legal powers to the hilt: We're going to audit far more real estate investors than ever before, thanks to the 1982 tax bill. We're going to hit individual investors with tax penalties so stiff their heads are going to spin. And we're going to prosecute tax shelter promoters aggressively if they've been intentionally ripping off Uncle Sam.
That's the message -- though not the precise language -- that emerges from discussions with key IRS officials as well as with top legal and accounting practitioners. The message should be a sobering one for an industry that's been growing explosively, despite the overall recession in housing and commercial construction.
New real estate partnerships offered this year are estimated to be in the $15 billion range -- involving thousands of limited partnerships that invest in everything from rental apartments to commercial office buildings and resort time-sharing hotel projects.
The bulk of these investments take the form of small partnerships created to acquire and operate specific pieces of property. Often the investments are located in the same region or state as the investors.
For example, a group of 10 to 15 friends might each put up $5,000 to $10,000 to acquire and rehabilitate a small, 50-year-old office building. The investors could qualify for a 20 percent federal investment tax credit on the rehabilitation expenses and take significant tax deductions for depreciation, interest and other expenses.
The initial deductions could offset the investors' rental and other income, such as from their regular employment, thereby providing a tax shelter for each of the partners.
If all went well and the building gained steadily in value, the group might sell the property after a period of years and divvy up sizable after-tax profits for everyone involved.
Most real estate limited partnerships of this type are legitimate, but a minority exist in a legal twilight zone: They're set up for the primary purpose of tax avoidance. They are designed from the start to yield extra large tax benefits to the investors, even if that means using questionable or illegal appraisal, financing or accounting techniques.
For instance, one time-sharing partnership offered recently in a number of states promises a $15,000 first-year write-off in exchange for a "down payment" of just $2,100. A husband and wife with a taxable income of $30,000 could cut their federal taxes from nearly $6,000 in 1982 to just $1,900 in 1983 simply by buying into this deal -- or so the promoters claim. A slightly higher initial investment would reduce the couple's taxes to zero, the prospectus says.
Another limited partnership tax shelter plan offered in the Florida area this summer promised $3.50 in deductions for every $1 in up front capital. The quick losses would be generated by rental home acquisitions in the Sun Belt, according to the prospectus, and the investment would be well suited to high-income busy professionals, such as doctors and dentists.
The problem with such investment "opportunities", though, is that they've suddenly become more dangerous than ever for the individual investors who (often innocently) sink their dollars into them.
The 1982 tax law permits the IRS to audit the books of entire partnerships instead of having to work taxpayer by taxpayer as it has traditionally done. The law also empowers the IRS to levy large cash penalties for "substantial understatements" of income taxes by individual partners and to assess heavy fines against partnership organizers who knowingly overestimate the value of real estate in order to inflate write-offs for depreciation and interest.
Apart from the tax law, though, the IRS has decided to get tough on certain techniques commonly used to calculate cash flow and deductions in real estate partnerships.
One method, known as the "rule of 78s," was once used primarily by financial institutions to compute interest charges on short-term loans. It has in the past two years been adopted by many real estate tax shelter promoters. (If you are an investor in a partnership, you may find it mentioned in the fine print of your prospectus.) The effect of the techique is to exaggerate greatly, or "front load," the interest deductions generated in the early years of a long-term real estate loan.
When combined with other questionable techniques, such as inflated property appraisals and so-called "add on" interest calculations to puff up write-offs, the "rule of 78s" can turn an ordinary investment into a virtual non-stop tax deduction machine.
The IRS hasn't formally announced it yet, but sources inside the agency confirm that use of the "rule of 78s" is likely to be restricted severely later this year in connection with long-term real estate financings. If the agency's policy ruling is made retroactive -- and, reportedly, it may be -- thousands of small investors' tax deductions from past years could be affected.