Pitfalls of limited partnerships are not obvious to novice
Dorothy and her husband are close to retirement. Both have worked hard, but neither ever made a lot of money.
A few years ago Dorothy inherited some money and her husband's income increased. Their taxes also rose, and a friend recommended a local financial consultant.
The consultant immediately recommended investing $5,000 in a limited partnership involving an oil and gas exploratory drilling program. When she read the prospectus, Dorothy said she was scared when. The consultant told her, ''Don't worry, this will make you rich.'' As part of the deal, Dorothy and her husband signed a letter of credit from a local bank. It obligated them to pay an extra $24,000 if the drillers needed more money. The drillers did. So far, aside from the tax breaks, Dorothy and her husband have gotten back $800 in income on their $29,000 investment.
Dorothy also invested in a series of six other limited partnerships. One involved a hotel. It eventually went bankrupt. Another purchased precious gems, which quickly lost half their value. Looking back on it, Dorothy (not her real name) comments, ''We were not sophisticated investors, . . . and being so close to retirement we needed income, not losses.''m
Dorothy's experience is not unique. Tax shelters are complicated investments, which should only be used by sophisticated investors. The prospectuses - which, if read, can be quite revealing - often are merely skimmed through. Even if read , they are often long, complicated, and difficult to understand. However, every year stock brokers, financial consultants, and others recommend investors plunk down cash in limited partnerships. Some should invest; some shouldn't.
Investment advisors differ somewhat as to how much income you should have in order to invest in a limited partnership. Thomas Spear, vice-president of the Asset Management Group, a fee-for-service investment counseling firm with offices in Colorado, California, and New Jersey, says he believes individuals who are not in the 50 percent tax bracket should consider something besides limited partnerships.
Other options include Individual Retirement Accounts, or Keoghs for the self-employed; investing in utility stocks that have dividend programs offering tax advantages; and investing in home insulation to take advantage of energy tax credits. Once you have used up all these options, Mr. Spear suggests looking at limited partnerships.
Robert A. Stanger, in his new book, ''Tax Shelters: The Bottom Line,'' notes that as a general rule, tax shelters shouldn't reduce your taxable income below person. He figures this income level will be about the 38 percent bracket by 1984. He says he recommends this level because ''Tax shelters are usually priced to produce a reasonable return only for investors benefiting from tax savings at this rate or higher.''
According to regulatory statutes, investors in most limited partnerships must also complete a net-worth type of financial statement. For most oil and gas programs, an investor must have a net worth of $225,000, not including personal property, or a net worth of $60,000 and a taxable income of at least $60,000 a year. Some states have their own laws and even higher standards.
Once you decide to hand over your cash to someone heading towards the oil patch, there are some important things you should know about most limited partnerships:
* Limited partnerships typically have low or limited liquidity. In other words, if you need the money you invested within a certain time period, make sure you can get it back when you want it. Some limited partnerships have a specific date when they intend to liquidate the partnership, others require the funds to be rolled over into future projects. It's often very difficult to liquidate a partnership.
* Be prepared to pay a commission. Limited partnerships are sold, not bought. Commissions of 7 and 8 percent are common. Legal and other fees are extra and can add on another 7 or 8 percent. Mr. Spear says he has seen limited partnerships in which commissions and fees absorbed from 30 to 40 cents of each dollar invested. ''The partnership must do extremely well to recoup that front-end load,'' he says.
He particularly likes partnerships in which the syndicator gets some reward if the project does well. ''You want their economic well-being tied to the project,'' he says. Some advisors also recommend partnerships where the general partner invests some of his own money - not just his fees - in the project.
* Analyze the partnership from an economic point of view, not just from a tax viewpoint. If you are investing in avocado farms, ask yourself, 'What is the market for the fruit'? If you are investing in oil and gas, find out where the drilling is to take place. Is it a risky area, have other discoveries been made there? If you are investing in a development program, you should find out the life of the reserves, says Barrie Damson, chairman of Damson Oil Corporation, a major syndicator of oil and gas programs. Is there enough oil in the ground to get you through to when the current oversupply ends and prices rise again?
* Find out what the past track record of the syndicator is. This is not always easy. Ronald Roberts, president of Landsing Securities Corporation, which syndicates real estate deals, suggests investors might only want to deal with the top 10 to 15 syndicators. Mr. Damson says it's important to make sure the general partner has financial strength and liquidity. You don't want to invest with a company that won't be around when things get tough.
Stanger & Co. recently ranked according to past performance over 600 oil and gas drilling fund programs put together by a total of 40 sponsors.To get hold of this listing write to: Stanger & Co.; 623 River Road; Fair Haven, N.J. 07701. The summary study costs $15; an in-depth report, ''Stanger's Drilling Fund Yearbook - 1982,'' to be published at the end of November, will cost $75.
* Try to make sure the limited partners have some control over the partnership. For example, if the general partners are not doing their job, the limited partners should have the ability to replace them. In a large partnership it might be difficult to get all the limited partners together. But in a smaller partnership, it should be possible.
* Know your liabilities. If you are dealing with an oil and gas program that requires you to get a letter of credit from a bank, assume it will be called. The Internal Revenue Service requires risk. If there is no risk that your letter of credit will be called, it might not qualify as a legitimate tax shelter.