Tax Revision Bill: Experts Predict Some of the Winners and Losers : The Bite May Not Be Deep for Investors

It’s not a question of whether the “barking dog” known as 1986’s historic tax reform “bites,” or not. He does.

But, as the smoke clears, evidence also mounts that the bite damage to the average, relatively small real estate investor will be skin-deep at worst.

The key phrase, however, is “average, relatively small.” In the higher income strata the bite deepens.

“I may be the only one in the real estate industry who thinks that it’s terrific. But I love it!” That from Marvin Starr, editor of the prestigious Oakland-based The Real Estate Tax Digest.

“The surprising thing about it is how little of the conference committee’s report, quantitatively, was devoted to real estate. Qualitatively, yes, it was significant, but I’ll tell you now, there will be more tax benefits in real estate, relative to other investments, than under the old law.”

High Roller Risks

Where blood will be seriously drawn, observers say, will be largely confined to the ranks of the high rollers: developers and syndicators who proceed (or have irrevocably gotten themselves involved) with real estate projects that “don’t pencil out on the bottom line” without the ability to write losses off against other income.

But again back to the average real estate investor--from the mom and pop landlord with two or three rental units to the professional seeking a diversification in his investment portfolio, or to the small investor buying a few units in an income-oriented real estate limited partnership. The impact of the proposal that is expected to be signed into law next month should be “modest,” “insignificant,” “negligible,” experts feel.

What has unduly frightened some small real estate investors, Starr concedes, “is the language of the bill, which is ambiguous, misleading and extremely confusing to the public. It’s this suggestion that all rental income property is a ‘passive’ investment without any regard for how active you actually are that throws people.

Passive Income Category

“The key to the whole thing for the small real estate investor is whether your income does, or doesn’t, exceed $100,000. If it doesn’t, then you can write off up to $25,000 in real estate losses against other income. It’s the single exception to what is otherwise categorically and arbitrarily determined to be passive income.”

A curious irony here: While the investor using a professional property management firm to handle his rentals has the freedom to write off losses up to $25,000 against other income (which is gradually phased out when the taxpayer’s income reaches $100,000 and totally eliminated when it hits $150,000), the investor with an income in excess of that but who works as his own property manager 24 hours a day can write off his losses only against rental income generated. So much for the fine-line “active” and “passive” distinctions.

“Most small real estate investors,” Starr adds, “aren’t in it to generate big tax losses. They’re after income, they’ve got moderate leverage, and their income normally exceeds their expenses, anyway.”

The impact of the legislation on one favorite avenue for the small real estate investor--the vacation home rented out sporadically--also seems minimal, but with one important proviso, according to Joe Knott, partner in charge of tax practice for the Los Angeles office of the Kenneth Leventhal & Co. accounting firm.

Put in Business Category

“If he occupies the home for more than 14 days a year--or more than 10% of the time actually rented, whichever is greater--then it classifies as a second home and, against the income generated, he can offset allocated interest, taxes and other expenses, but not below zero, of course.”

Occupying it no more than 14 days a year for personal use, Knott continues, typically puts it in the business category, as under present law, and subjects it to the same new rules governing any rental-income property--and the same $25,000-a-year write-off and $100,000-a-year income rule mentioned earlier.

“But here,” according to Gary Fowler, president of Beverly Hills-based Fowler Investment Inc., international real estate consultants, “the situation could get a little sticky for a lot of people. Because, when you’re talking about second homes used as rentals in places like Palm Springs, you’re also talking about a lot of people with incomes clearly in excess of $100,000.”

And at that point the “active-passive” rule kicks in and passive losses--interest deductibility, homeowner’s fees, insurance, maintenance, depreciation, etc.--can be written off only against active income generated. And the typical vacation home, under the best of circumstances, rarely produces a positive cash flow.

Time-Share Industry

“This could impact billions of dollars in second-home developments,” Fowler adds.

Another victim of the proposed legislation--although not of the scope of the second-home market--is the time-share industry, where buyers buy one, two or three weeks of “right-to-use” occupancy of a condominium unit in a resort area. Because such purchases are normally financed through installment notes, they fall--under the new law--in the same category with any consumer interest expense--such as an auto loan--where the deductibility will be phased out over the next two years: only 65% of it deductible in ’87 and 40% in ’88.

“One solution here,” Leventhal’s Knott suggests, “would be for the time-share buyer to refinance his home to pay off the time-share and other similar obligations. However, there’s a limit here, too, of course, since the deductibility of the interest on refinancing is limited to the original purchase price of the home, plus the cost of any subsequent improvements.”

One highly predicted real estate “disaster area” of the new tax legislation--on closer examination--has proved to be far more smoke than fire as far as the average real estate investor is concerned: among buyers of participation units in real estate limited partnerships.

Popular Syndications

Enormously popular the last few years, the “public” syndication route has offered small investors the same real estate “pooling” long available to large investors through “private” offerings.

Limited partnerships--available in “units” of $5,000 to $10,000 each--involve the investment of millions of dollars from small investors under the banner of a general partner who acquires, manages and ultimately sells (presumably at a profit) a wide variety of commercial and industrial real estate--apartment complexes, shopping centers, office buildings and industrial complexes. Income generated, tax advantages and capital gains garnered when each limited partnership is closed out are pro-rated among the limited partners.

But, obviously, these were a prime target of the tax writers in specifying that the losses incurred in such passive real estate investments could only be charged off against actual income generated--and in making any profits in the resale of the property taxable as ordinary income instead of as a capital gain.

“Real estate syndications,” The Real Estate Tax Digest’s Starr adds, “were the prime reason for the curious wording in the law about ‘active’ and ‘passive’ participation. They weren’t going to let the syndicators get around it by simply declaring all of their limited partners something like ‘non-managing general partners.”

Particular Vulnerable

Particularly vulnerable was a type of syndication that came into vogue several years ago--the heavily leveraged limited partnership, where as little cash as possible was paid down and a heavy debt load (deductible) was assumed.

The result was a limited partnership 100% geared to paper losses that could be written off against the investors’ other income and, frequently, entailed a continuing pay-in commitment on the investors’ part over three, five or seven years.

For such tax-oriented syndications, the next tax bill does, indeed, spell unmitigated disaster as the limited partners not only find themselves facing stiff actual losses that can’t be absorbed but, in the case of those signing future commitments, throwing even more good money after bad over the next few years--or simply defaulting on those commitments and facing the legal consequences.

“Disaster,” or not, though, there is growing evidence that such tax-oriented limited partnerships--appealing almost exclusively to the very wealthy--were never as large a factor in the syndication business as popularly supposed. That the vast majority of small investors in real estate limited partnerships had opted, instead, for income-oriented syndications where real profits are generated, against which standard losses can be written off.

‘Bought for Economic Reasons’

New York-based Integrated Resources, as a case in point ($1 billion-in-assets), sensed the mood of Congress about two years ago, according to a recent interview with senior executive vice president, Joel M. Pashcow, and, since then, “we haven’t been willing to put together any deals that didn’t have a double-digit economical return.”

And, in other instances, large syndicators such as Skokie-Illinois-based Balcor (400,000 investors, $2.5-billion in assets and $5.5-billion under management) simply never saw any advantage in the tax-oriented limited partnership in the first place.

“Thank goodness,” Balcor’s president, Jerry M. Reinsdorf, said in a recent interview here, “we never got involved in that deep-shelter end of the business. We’ve always bought for economic reasons. On a plain vanilla type, small shopping center, for instance, we’re looking for a 9% to 9 1/2% rate” of return. Balcor has been a wholly owned subsidiary of American Express Co. since 1982.

Reinsdorf says more than half of its syndications “have been sold to tax-exempt investors, pension funds and to holders of Keogh and IRA plans” where tax-sheltering would have been superfluous, anyway.

Feeling the Jitters

But, like virtually all syndicators, even giant Balcor has felt the pinch of pre-tax-overhaul jitters. “We sold about $950 million last year,” Reinsdorf adds, “and all but about $100 million of that was in public syndications. This year we’ll be lucky to raise $600 million.”

(Feeling beleaguered, however, is a way of life with the affable Reinsdorf who, as co-owner of two Chicago-based athletic teams--the Chicago Bulls and the Chicago White Sox--is not only on the grill for their current losing streaks, but is also being hanged in effigy for announcing his abandonment of historic, but decaying Comiskey Park on Chicago’s south side).

Between real estate syndicators who never got involved in tax-oriented limited partnerships in the first place, and those that got in--but then out when the mood of Congress was sensed--”I doubt if more than 20% of all syndications today, if that, are into tax-oriented deals,” according to a guess by Beverly Hills real estate consultant Fowler.

“I’d guess that the overall impact of this on the small real estate investor is negligible,” Fowler adds, “although, psychologically, it’s very jarring. Most of the syndications you’re going to see being put together in the future are going to be like the hotel limited partnership we’re working on now--where we’re looking at a return of about 10%.”

‘Substantial Tax Benefits’

For real estate investors, lawyer-editor Starr says emphatically, the allure is still there. “You’ve still got substantial tax benefits that other investments don’t have. By restoring the internalized benefit, we will begin to produce tax-free, spendable income which will grow in value and will be essentially tax-free until you sell it.

“We’ll still have refinancing, which is tax-free. We’ll still have an appreciation in value and a hedge against inflation.

“Capital investment, seeks its present highest and best return after taxes--not yesterday’s taxes, but today’s. You don’t cry about yesterday. Real estate is going to come out of this in a more preferred position than ever before.”