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"The Most Lucrative Tax Shelter In American History"

A Quick and Dirty History of Tax Shelters"

  • Prior to the Tax Reform Act of 1986 billions of dollars were invested in real estate by investors who were attracted by tax write offs (these were the so "tax sheltered investments").
  • In the early 1980's the biggest tax goodie was "accelerated depreciation" wherein real property could be depreciated over artificially short periods of time with a large percentage of the tax write-offs being taken in the early years.
  • These substantial tax benefits were then sold to investors through the sale "limited partnership" shares. As a result, many real estate projects were undertaken not because they necessarily made economic sense but because of the tax write offs.
  • The Tax Reform Act of 1986 did away with accelerated depreciation and most other forms of tax shelters.
  • The 1986 Act did, however, create a new tax shelter for investors in affordable rental housing. This was the Low Income Housing Tax Credit Pro gram (LIHTC).

What is the Low Income Housing Tax Credit?

  • LIHTC allows developers of qualified rental housing to take a credit on their tax returns. The credit spread out over a 10 year period and it can be for as much as 90% of the actual cost of construction (with a somewhat lesser percentage for the cost of rehabilitating of existing units).
  • The apartments have to be affordable to persons earning less than 50% of the median income of the locality. Affordability must be maintained for at least 15 years.
  • Developers (including non profit corporations) can raise capital for their affordable rental housing project by doing the deal with a "pass through" type of entity the then selling ownership interests to investors. A "pass through entity is one that the IRS treats as partnership where the tax "goodies" pass through to the investors(as opposed to most corporations where the there is double taxation and the tax goodies do not pass through to the stockholders). Typically limited partnerships and limited liability corporations (LLC's) are the entities of choice.

Choosing The Right Entity
  • When two or more people want to participate in real estate development, some kind of "structure" has to be created to facilitate their involvement. This can either be a corporation or some kind of partnership.
  • In order for the investors to claim the low income housing tax credits the entity must be taxed like a partnership and not like a corporation.. The difficulty is, however, the investors also want the limited liability of a corporation.
    • HOW CORPORATIONS ARE TAXED: Corporation are taxed just like individuals and the shareholders can not claim the tax "goodies" on their own individual tax returns.
    • HOW PARTNERSHIPS ARE TAXED: Partnerships, however, do not pay tax at the partnership level. All the taxable gains, losses, and credits pass through to the individual partners and are reported on their own individual tax returns.
  • "SHAREHOLDERS" ENJOY LIMITED LIABILITY: shareholders of a corporation are not liable for the corporation's debts (i.e. liability is limited to the dollar amount of the shareholder's investment)
  • "PARTNERS HAVE UNLIMITED LIABILITY: Members of a partnership can be sued for partnership debts. The creditor can choose to sue only one partner and the court can award a judgement for the entire debt (not just that particular partner's share of the debt).

What are "Limited Partnerships" and "Limited Liability Companies" (LLC's)
  • Limited Partnerships and LLCs are taxed like patnerships but have the limited liability of a corporations. Thus, selling shares in a limited partnership is the ideal vehicle for a nonprofit to attract investors to their LIHTC projects.
  • Limited partnerships and LLCs are very similar. They are special types of entities authorized by state law. If it is properly set up they are taxed like a partnership but the investors enjoy limited liability similar to shareholders of a corporation.
  • A limited partnership must have one or more "general partners" who have unlimited liability. In addition, there would be one or more limited partners who have limited liability (but who are taxed like "partners" and not "shareholders"). An LLC, on the other hand, all of the "members" have limited liability/
  • The limited partners (or LLC "members") are the investors who contribute all of the money. Limited partners are not allowed to play part in the day to day management (whereas members of an LLC can). These investors are allowed to deduct a portion of the depreciation and other deductions and take credits on their individual tax return thereby sheltering their other income and paying less overall taxes.
  • The general partners are allowed to keep substantial "developer's fee" for their efforts.

Passive Investment Rules
  • Before 1986 tax shelters were often sold to rich individuals who needed tax write-offs to shelter their otherwise taxable income.
  • In most cases these investors were "passive" meaning that they took no active part in the management of the properties.
  • The 1986 Tax Reform Act, however, prohibits "passive" investors from claiming deductions and credits generated by their properties. An exception was made for corporations. For this reason shares in a LIHTC eligible limited partnership can only be sold to corporations.