Tax Shelters Will Change, Not Vanish, Under Reform

Contrary to the avowed mission of those who seek genuine tax reform in this country, tax shelters will not completely disappear even if the Senate Finance Committee bill becomes law.

That’s because the plan put forward by Sen. Bob Packwood (R-Ore.), the Finance Committee chairman, continues to give preferential treatment to several items of income or deduction in calculating one’s annual income-tax liability.

Such is the case with home-mortgage interest expense. This is the only form of consumer interest expense that remains tax deductible; all other interest incurred to finance personal consumption, such as the purchase of the family car, becomes an element of non-deductible personal consumption itself.

If the Packwood plan passes, there most likely will be pressure on the business community to come up with innovative credit instruments to allow taxpayers to use their homes as collateral for all or most of their credit needs.

Already there is talk in banking circles of offering credit cards secured by a second trust deed on real property held for personal use. The credit line could be used to buy a car, take a vacation or go out to dinner, and, because the card would be secured by a first or second home, all interest payments would then become tax-deductible.

On the investment side, losses generated from most passive tax-shelter investments (among them investments in real-estate limited partnerships) will no longer be deductible against other unrelated income earned during the year. In addition, gains on the sales of appreciated properties will be taxed in full with the proposed repeal of the 60% long-term capital-gains deduction. Does this combined “one-two” punch spell disaster for the real-estate investment industry? Or will the marketplace be able to sidestep these blows by packaging real-estate investment opportunities in a slightly different form?

To avoid the passive tax-shelter loss limitation in the Packwood plan, investors in real-estate shelters might consider becoming shareholders in “small-business corporations” (commonly known as S corporations), where they would be considered actively involved in the management of the company. Such an adjustment would not be without its cost, however. Investors would have to be willing to forgo the limited legal liability that they currently enjoy as limited partners for continued “flow-through” of investment losses on their individual returns. This is because shareholders in small businesses or closely held corporations are typically asked to personally guarantee the loans of the corporation itself. In any event, investors should only dispose of their appreciated real-estate holdings by swapping with other real-estate investors, avoiding the payment of tax that would normally accompany an outright sale of appreciated property for cash.

Other tax-shelter investment opportunities may actually be strengthened by this legislation. Oil and gas may be deluged with a massive inflow of capital investment because tax-shelter losses reported by investors who have “working interests” in oil and gas ventures will remain deductible against other income. Various special benefits unique to the industry, such as percentage depletion and direct writeoff of tangible drilling costs, will also be retained. In effect, a tax-shelter “monopoly” has been created by simply changing the tax treatment of all other passive investment activity relative to it.

Let us not forget that progressive income taxation is still alive and well, although only a shadow of its former self. Nonetheless, where some individuals will be taxed at 27% (or even higher for families that earn $75,000 to $185,000) and others at 15%, higher-income taxpayers will continue to transfer investable funds or income to lower-income taxpayers to take advantage of the lower marginal tax rate. Permanent gifts of capital to lower-income family members such as children and elderly parents should thrive, as should temporary trusts and lending.

Unlike the dinosaur, tax shelters will adapt to their new surrounding environment, changing shape to accommodate any shift in tax preference brought about by a change in the law.