Tax shelter overhaul stresses true cash return; better value seen
You've taken the lunch hour to stroll over to your broker's office when a man lingering in a doorway beckons to you. ``Psst. Hey, bud. Wanna buy a hot tax shelter?'' He opens his imitation Burberry and reveals an array of oil deals, land deals, building deals, equipment deals, windmill deals. Write-offs of 4, 5, even 6 to 1 are ``guaranteed,'' he says. Being a smart investor who stays tuned to the financial press, you know something is amiss, because the days of high-write-off tax shelters are gone. The picture of an Internal Revenue Service auditor cocking one eyebrow as he scans your tax return prompts you to look straight ahead and hurry into the offices of Traditional Investments Inc. and invest in a real estate deal with good economics and a meager 1-to-1 write-off.
Good move, because the IRS and Ronald Reagan have put the clamps on high-write-off tax shelters, forcing the investment industry to bring out financial products that rely more on cash return than tax deductions for appeal. For investors, the move probably means higher taxes and fewer but better investments to choose from.
The tax shelter business, buoyed happily by tax reform bonuses four years ago, will now have to kick vigorously to make much progress this year. The boost the Reagan administration gave in 1981 is being taken away.
Both the Tax Reform Act of 1984, which took effect Jan. 1, 1985, and the proposed ``flat tax'' reform being debated this year will let the air out of all kinds of tax shelters.
Under the former, those with high-multiple write-offs are a thing of the past. Allowable tax deductions will shrink, forcing an emphasis on an investment's true cash return. And the industry will probably attract fewer investor dollars without the tax benefits of the past.
``This is the year when cash flow will be king,'' says Fred Newberg, president of EnergySearchcq Inc., an investment subsidiary of Butcher & Singer Inc. in Philadelphia. ``Investors will be comparing every type of investment to a bond or some other guaranteed yield.''
Looming over any 1985 investment scenario is the Treasury Department's flat-tax proposal. If passed as now written, it would both eliminate the need for most investors to seek tax shelters and sharply curtail -- perhaps completely -- those that are available.
First, the impact of the Tax Reform Act of 1984:
Out of the picture, says Lyle Hall, will be the abusive tax shelters that have irked the IRS for years. Mr. Hall, a senior vice-president with Butcher & Singer, explains that the multiple-write-off shelters which relied on tax benefits instead of real yield will lose their footing.
Gone are such favorite devices as:
Marking up a property beyond its real value, thus allowing for higher depreciation deductions.
Taking huge deductions for interest and other expenses that were charged but not yet paid.
Distributing partnership income internally to disguise taxable income or create artificial deductions; instead, both investors and shelter promoters will pay hefty new penalties for engaging in such practices.
Investments with strong economics and a secondary emphasis of tax benefits will continue to dominate the business, Mr. Hall says. Those that offer investors fat tax write-offs and slim economics will fade away. ``Our product line has not changed,'' he says. ``The first thing we have always done is look at an industry and say, `Would we put our own money in there without the tax write-offs?' You don't have to make obscene profits, but you do need to have strong economics. We have never been into the exotic, high-write-off investments.''
``I don't think anyone in the business cares about losing abusive shelters,'' adds John Everets, executive vice-president of sales and marketing at Advest Inc., a Hartford, Conn., brokerage. He notes, though, that the act brings important changes to even the most economic, tax-related investments.
The depreciable life of real estate investments, for example, has been lengthened and accounting practices relating to partnerships have been rewritten in great detail and complexity.
The bottom line is an overall general shrinkage of tax benefits. Real estate, oil and gas, equipment leasing, and other tax-related investments that used to bring 3- and 4-to-1 write-offs will arrive with 2-to-1 write-offs at best and 1 to 1 on average. ``Deep tax shelters will not occur anymore,'' Mr. Everets says. ``Those that make sense will be restructured.''
For that reason, he and others predict better value for investors. ``Before, you had too many dollars chasing too few . . . deals. Now we'll see fewer investor dollars to compete for.''
The real estate business now offers some of the best opportunities in years, the experts say. Real estate investments have reentered the marketplace in force, bringing two and three years of depressed prices with them. The potential for renewed inflation, combined with low, fixed-rate mortgages now available, adds up to high yields five to 10 years down the road, says Mr. Newberg.
He also likes oil and gas drilling projects, since oil prices have stayed flat while drilling costs have dropped between 50 and 60 percent. ``That's a contrarian view, of course, but I think investors who are willing to take some risk now and who go with companies that have good track records could see some of the best returns ever.''
Cable TV partnerships that finance either the construction or purchase of cable franchises also figure high on recommended lists. Heavy plant depreciation gives them attractive tax benefits, and recent congressional deregulation promises to encourage high cash returns.
Such perspectives, however, could be about as meaningful as a weather vane in the path of a tornado, says Furhman Nettles, vice-president of Robert H. Stanger & Associates, which follows tax-sheltered investments. The ``flat tax'' reform from the Treasury threatens to pull up most of the tax shelter industry by the foundations and send it packing to the Land of Oz.
``The outlook for shelter market right now is cloudy, foggy, and dismal, because we don't know what will happen with the tax law,'' Mr. Nettles says. ``If the flat-tax proposal is introduced as proposed, it will mean the end of the sale of publicly registered limited partnerships,'' which constitute the bulk of tax shelter sales, Nettles comments. He emphasizes the Treasury need only introduce the flat-tax legislation to yank the rug on shelters. The proposal says that important sections would be retroactive to the date of legislative introduction.
``Uncertainty is not an enhancer of confidence,'' Nettles says, and the flat-tax proposal has already taken a bite out of December tax shelter sales.
The proposal would reduce the 50 percent tax bracket to a 35 percent bracket -- eliminating most investors' need for any tax shelter -- and close down accelerated depreciation and investment tax credits, features that are vital to the economics of tax shelters that invest in real estate, oil and gas drilling, and equipment leasing. It would also cut out two other important tax benefits of oil and gas drilling, the intangible drilling cost deduction and the percentage depletion allowance. And it would do away with capital gains, which taxes the profits of long-term investments at a lower rate.
Most worrisome to Mr. Nettles and others, though, is a proposal to tax limited partnerships with more than 35 partners as corporations, effectively putting them out of business. In 1984, limited partnerships raised $7.81 billion, down 6.4 percent from 1983.
``I don't think that has a prayer of passing,'' says Mr. Everets, ``. . . but I think it's important for people to think about the things that partnerships have built in this country: office buildings, apartment buildings, cable systems, oil and gas wells. . . . They play an important role.''