The Internal Revenue Service has fired the first shot in a new war against real-estate tax shelters, and apparently has scored a direct hit.
In a move that Justice Department officials described as highly significant for real-estate investors across the country, the government has obtained a consent agreement from a Texas firm that the government had allegedly offered town house buyers excessive tax write-offs.
Unlike prior cases involving real-estate tax shelters offered to small-scale investors, the Justice Department used new legal powers to search out and attack promoters while they were selling to the public, rather than hitting taxpayers years later through time-consuming individual audits and suits.
One Justice Department official said that at least eight other cases against real-estate shelters are being put together right now, but can't be identified publicly yet.
The Texas firm, Gibraltar Properties, Inc., of Dallas, signed a consent decree in federal court enjoining it from selling any further "timeshare" units in a condominium located on Lake LBJ outside Austin. The consent decree and court order did not determine whether Gibraltar's past conduct was improper.
Gibraltar denied any wrongdoing on its part.
The Justice Department's court complaint alleged that the firm marketed a shelter plan designed to cut investors' annual federal taxes to zero, through overvaluation of property and inflated mortgage-interest deductions.
Here's how the Justice Department alleged the shelter worked, according to the complaint:
Investors were offered the right to buy ownership shares in a lakeside resort condo. Title to the condo, however, was chopped into 357 equal pieces. A week of each year is usually set aside for maintenance.
Each share carried a price tag of $3,000, with a required downpayment of $750. Every investor had to sign up for at least seven shares, covering seven days during the course of a year during which he or she could use the town house.
Investors' cash outlays were kept small. The bulk of each timeshare-purchaser's cost would be financed by Gibraltar, in exchange for a 30-year promissory note secured only by the condominium itself. In other words, no investor had personal liability ever to repay the note.
Buyers would owe Gibraltar $600 a year per share from 1983 through 1990. No further installments would then be required until the year 2012, when a massive balloon payment of $78,670 per share would come due. The owner of a standard seven shares would need $550,696 to pay off Gibraltar's balloon note in 2012.
The Justice Department and IRS attacked the day-by-day timeshare concept on two legal grounds. First, they contended in the complaint, Gibraltar grossly overvalued the true economic worth of the resort condo. At $3,000 per daily share, the market value of the town house would have to be over $1 million--"an utterly preposterous notion," in the words of one federal attorney.
Second, the complaint alleged, the tax-shelter promoter created additional large deductions for investors by using an accounting technique known as the "Rule of 78's." In plain terms, the Rule of 78's is a method for computing accrued interest that permits exceptionally heavy write-offs in the early years of a loan.
The net effect of these two alleged deduction-boosting features, said a Justice Department official, would be to turn a town house-timeshare purchaser's small investment into a money-making machine.
For every dollar investors put into the Gibraltar plan, the Justice complaint alleged, they could deduct seven or eight dollars at tax time during the early years of ownership.
If the tax shelter operated as alleged in the complaint, for instance, a $600 per-share payment in 1983 could mean a tax write-off of $5,065.39 for an investor. By owning the required minimum of seven shares in the town house this year, the investor could deduct $35,457.46 next April 15--all for a $4,200 cash outlay.
The Justice Department calculated in the complaint that the typical investor in Gibraltar's plan could have written off more than $286,000 in federal tax deductions during the first nine years, but would have spent only $38,850 in hard cash.
"If we let real-estate deals like this go unchallenged," a Justice official said, "nobody in America would pay a cent in taxes."
That's why the IRS is now gearing up to make heavier use of powers of injunctions and stiff fraud penalties to fight tax shelters that the government considers abusive.
As a small-scale investor, what should you look for to stay clear of the fray? Three telltale characteristics are under increasing IRS attack: High-ratio write-offs (such as $4 in deductions or more for every dollar you invest) always raise eyebrows at the IRS. So do possible overvaluation of property, and use of interest computation techniques like the Rule of 78's.
Avoid them if you want to cut your chances of audit problems with the feds.