What Is Left in Tax Shelters

Some remain, though many have been blown away by a new law

Oh, a storm is

threatening

my life today,

If I don't get some

shelter, oh

yeah,

I'm gonna fade

away.

Those mournful lyrics from the Rolling Stones' rock classic Gimme Shelter touched a generation of troubled youngsters in the late 1960s. Today the lines might serve as a lament for affluent investors who are watching some of their tax shelters being blown away. The winds of change are coming from the Internal Revenue Service and Congress, which greatly restricted tax avoidance schemes in the Tax Reform Act of 1976, and continued the attack in the latest law, which becomes fully effective on Jan. 1.

Shelters enable people to generate paper losses to write off against their regular income, thus shielding their cash from the full bite of the IRS. Generally a group of investors forms a partnership, which enables members to claim personal deductions proportionate to the money they put into the group's investment. In a corporation, on the other hand, losses are charged against the company and provide no individual tax benefits.

The partnership buys into any property--movies, coal mines, lemon groves --on which fairly rapid depreciation is allowed. That enables the members to write off in four years or less most of the value of the property, even though it might continue to generate income for decades. When the depreciation benefits are fully realized and the investors have recaptured much of their original investment through write-offs, they can sell the property. The profits from the sale are taxed, but usually at favorable capital gains rates, which under the new law have been reduced even further, from an effective maximum of 49.1% to 28%.

What had made the shelters particularly fetching was that in most instances the investors had to put up only a small amount of their own cash. As a partnership they often borrowed the rest on a "nonrecourse" loan, paper for which the partners are not personally liable. If the notes were defaulted, the lender got the property, and the investors got their writeoffs from depreciation and had no worry about being sued for leftover debt.

For example, a promoter sold a lithograph stone plate. He figured that it was worth $40,000. But to make it attractive for tax purposes, he agreed to sell it to a partnership of investors for an inflated price of $100,000. They put up only $40,000 in cash and gave over the remaining $60,000 in nonrecourse notes made out to the promoter. Very often these notes were never paid off. Still, the partners got tax writeoffs of $100,000 because the stone depreciated with every print produced.

In 1976 Congress began to ban nonrecourse financing of investments in movies, farming, cattle raising, equipment leasing, and oil and gas drilling. In these deals people now may deduct as losses only the amount that they had personally put up or had at risk. The 1978 tax law extends that at-risk rule to investments in coal mining, master recordings, toy molds, lithograph stones and a host of other rapidly depreciable properties, many of which shelter promoters had dreamed up since the '76 crackdown. In addition the IRS has been taking a much harder look at so-called partnerships lately and reclassifying a growing number of them as associations if they fail to meet certain tests. That has caused many shelters to collapse because associations are taxed in the same way as corporations.

Of course, some tax havens remain. Apartment houses and the renovation of historical buildings are the most popular, largely because Congress took no steps to block nonrecourse financing of them. Thus a shelter partnership might raise $1 million from its members and $4 million in nonrecourse loans to convert a rundown building into federally subsidized apartments at a total cost of $5 million. Though the property could be assumed to have a useful life of 30 years, the investors may deduct the mostly borrowed cost over five years, providing them with $1 million a year in write-offs that they use to cut their taxable income from other sources. When the depreciation benefits are used up, the partners can sell the apartments, often at a profit.

Even without nonrecourse financing, oil and drilling deals are still attractive.

They offer substantial write-offs for the cost of labor, exploration and other "intangible drilling expenses," which often comprise 70% of the investment. If high-income investors hit a gusher, they get richer; if not, they do not lose much because a lot of their invested money would have gone for taxes anyway.

Leasing deals also retain their appeal.

Example: ten partners join in acquiring an executive jet for $2 million. Each of the ten puts up $200,000, of which three-quarters is borrowed money. The first year alone they can pile up deductions for accelerated depreciation and interest on personal loan debt, as well as a 10% investment tax credit. For each partner, that can work out to a $20,000 direct tax credit, plus a minimum of $80,000 in deductions. In a few more years the partners can recoup all their original investment in tax breaks despite having to pay a levy on income from leasing out the plane.

No one seriously expects that the closer IRS scrutiny or the latest tax law will permanently eliminate the more blatant dodges. Tax advisers are already at work figuring out ways to beat the tax code and, given its ramshackle structure, they are certain to find new loopholes.

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