Every time Congress decides to raise personal income tax rates, tax shelter salespeople come out of the woodwork, pitching all kinds of exotic investments designed to save you thousands of dollars in income taxes.
In the '80s, stockbrokers and financial planners sold zillions of dollars worth of real estate and oil tax shelters, most of which turned out to be investments from hell. Not only did the many of these tax shelters end up being worthless, many ill-fated investors got hit with IRS audits, had their deductions disallowed, and got billed for back taxes and penalties.BLAME THE 1986 TAX REFORM. Tax reform in 1986 eliminated most of the tax benefits of these tax shelters. Anytime you buy something for tax benefits instead of economic viability, you are asking for trouble. Never let the tax tail wag the investment dog.
President Clinton's new tax act has raised the top marginal personal income tax rate to 39.6 percent. I can hear the brokers dialing for dollars with new tax shelter programs.
TAX CREDITS. The new tax shelter craze these days is the low-income housing deals. Structured as limited partnerships, these tax shelters are either building or renovating housing for low-income renters.
These housing projects offer below-market rents to tenants who qualify as low-income. In exchange for these below market rents, Congress offers enticing tax credits. Remember, tax credits are better than tax deductions since they directly reduce your tax bill instead of reducing your gross income like a tax deduction.
CREDITS FOR 10 YEARS. Investors don't get all the tax credits immediately. The tax credits are spread out over the next 10 years. A $60,000 investment would give you approximately a $9,900 tax credit each year for the next 10 years. Add it up. You get almost $100,000 worth of tax credits for a $60,000 investment.
On top of those juicy tax credits, you also own the underlying real estate. Low-income housing promoters speculate that the real estate should go up in value duringthe estimated 15-year holding period, adding to the lucrative tax credits. These capital gains aren't guaranteed but could add to your total return.
The salesperson pitching you a low-income housing deal will tell you that the tax credits alone should provide a 10-12 percent return and perhaps more from real estate appreciation.
SOUNDS PRETTY GOOD. A lot of things sound good. Ask yourself the following questions before you plunge into one of these deals.
1. TAX LAW CHANGES. Since you have to wait a full 10 years to collect all the tax benefits, you are forced to rely upon the good graces of our politicians to continue these tax credit programs. They are permanent tax code features today, but do you really trust Congress to keep its word?
2. VERY ILLIQUID. It is close to impossible to get out of one of these deals before it unwinds without losing your shirt. There is virtually no secondary market to sell these partnerships, so you better plan on holding on for the full 15 years.
3. DON'T PLAN ON CAPITAL GAINS. Some of these low-income housing deals border on worthless after the partnership unwinds. Poor maintenance, tenant turnover and property damage can kill any chances for appreciation.
4. TIGHT FEDERAL RESTRICTIONS. If your partnership syndicator fails to follow strict federal guidelines, you could lose all your future tax credits and even part of what you have already written off. Failing to make sure the tenants meet the low-income thresholds is a violation.
5. WILL YOU QUALIFY IN THE FUTURE? You cannot claim your credits in years where you take the maximum $25,000 rental real estate loss OR if you are hit with the alternative minimum tax. Plus, your income may drop in the future so the credits wouldn't be very valuable to you.
Are these low-income housing credit partnerships a good deal? They could be, but I think there are too many potential problems that could spoil the party.
First, investors would have generally been well served by avoiding anything called a limited partnership. Secondly, I don't trust Congress to keep their word about anything, especially for the next 10 years. Thirdly, these deals are heavily front-loaded with commissions (15-25 percent) so the only person guaranteed to make money on the deal is the salesperson.