Tax Ramifications

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In the decade before reform, one of the major reasons for the high degree of tax shelter investment in real estate was that the "at risk" rules introduced by the Tax Reform Act of 1976 did not apply to any partnership in which the principal activity was investing in real estate. The "at risk" rules limited your tax deductions to the amount you invested plus the amount of borrowed funds for which you were personally liable. Real estate tax shelters were exempt from this requirement until January 1, 1987 (Tax Reform Act of 1986).

The Tax Reform Act of 1986 applies the at-risk rules to the activity of holding real property, with an exception for qualified non recourse financing. In general, taxpayers will be considered at risk with respect to their share of any qualified non recourse financing that is secured by real property used in the activity. The term qualified non recourse financing means any financing that is borrowed by the taxpayer (1) with respect to the activity of holding real property; (2) from a qualified person, or represents a loan from a federal, state, or local government, or is guaranteed by any federal, state, or local government; (3) except to the extent provided in regulations, with respect to which no person is personally liable for repayment; and (4) which is not convertible debt.

The combination of first-year accelerated deprecation and heavy start-up costs may produce tax deductions exceeding the size of an initial cash investment when 80 percent of the cost of that investment is financed with borrowed funds. What that means is that if investors are in the 31 percent bracket, their net initial cash outlay may be reduced to zero! However, with any tax shelter, as with any investment, never invest just on the basis of tax deductions alone. You must always consider the total expected cash flow from the property. The advantages of a real estate tax shelter are that the risks are normally minimal and the total cash flow is normally augmented in the early years by substantial tax savings. Furthermore, a good shelter should be structured to give you substantial cash rental income that is either minimally taxed or not taxed at all due to offsetting depreciation expense deductions even in the middle years. These depreciation deductions are pencil transactions that do not involve any real cash outflow, and they arise out of basis created by borrowed money. In effect, with a properly structured transaction you get to eat your cake and keep it too.

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