The Basics of Tax Shelters


Tax-sheltered investments fall into the category of investments having the highest degree of risk. Of the hundreds of tax-sheltered investments that I have reviewed over the past 20 years, 90 percent were very poor, economically, and the investor would have been better off paying taxes than making the investment. The remaining 10 percent that had merit required further culling, and we ended up with very few suitable investments for high-tax-bracket individuals. Even after careful, skilled selection, some of the shelters will probably end up being unsuccessful.

In advising clients on tax-sheltered investments, we emphasize diversification, and if there is substantial high-taxable income involved, we recommend that the shelters generate a 200-percent writeoff to the money invested. The investor thus risks the amount he otherwise would have paid in taxes. Our hope is that three out of five shelters would be successful, so that we would compensate for any mediocre success or perhaps failure. One of my other criteria is that I not represent a tax shelter unless it is an investment I would go into myself. In fact, I make it a practice to personally go into the shelters we are involved in. Of course this does not assure that the investment will be successful.

The tax-sheltered investments we generally deal with range in writeoffs from 100 percent of the money invested up to a 300-percent tax-anticipated writeoff. Of course the investments must meet regulatory standards, either being registered with the Securities and Exchange Commission or coming under registration exemptions but offering full disclosure, tax opinion of counsel, etc. We require that a client have programs that we might consider reviewed by outside advisors, generally a tax specialist C.P.A. or a tax attorney. The exception to this is when the client is experienced and sophisticated in tax-sheltered investments.

There is a variety of investment areas that can shelter income from taxes. Included are real estate, oil and gas, and mining—uranium, coal, precious metals, gold and silver, diamonds, sapphires, asbestos, and other basic metals. Agriculture also offers opportunities. One of the other prominent areas is leverage equipment leaseback shelters, another, the motion pictures. Then there are the exotic shelters involved with silver straddles.

The degree of economic risk in these areas of investment varies considerably, and each investment must stand on its own. Generally speaking, the higher the tax writeoff, the higher the risk of the initial investment. There is also a considerable amount of tax risk on high-leverage writeoffs because of the possibility of contingent tax liabilities coming back to haunt the investor. It is most important that the investor receive competent counsel.


Space limitations prevent my going into detail for all of these investment areas, but I think an overview of a real estate tax shelter would be of interest. Real estate is certainly a readily understandable investment since most people own their homes and are familiar with some of the benefits of such ownership—such as a tax writeoff for interest paid on the mortgage and for property taxes, the equity buildup derived from reducing the mortgage, and the value of the home as leverage against inflationary price rises.

In fact, most people think that homeownership offers them tax-shelter benefits, and to some extent that is true. People generally do not realize, however, that there is a bottom-line cost of living in a home that they own and that it really equates itself to the cost of renting. For example, let's say a person lives in an $80,000 home that has a $50,000 mortgage. The downpayment of $30,000 has an investment value, that is, if invested so as to yield eight percent net after taxes, it would have a value of $2,400 per year. In order to properly calculate the true cost of living in a home, such foregone earnings would have to be taken into consideration. Add the $2,400 to the mortgage payments, say $4,800 per year, and to the insurance and maintenance costs, say $1,500 per year, and to the property taxes, say $1,000 per year. This all totals up to annual expenses of $9,700. This would be reduced by the tax savings on the interest and property taxes. Assuming that the homeowner is in a 40-percent tax bracket, he will save $2,400 in taxes that year, so the net cost of living in the home is $7,300 per year. If part of the mortgage payment is going toward payment on the principal, the homeowner would consider that he is building equity in his home.

It is my contention at this point that the homeowner is, in effect, paying the equivalent of rent. The one main advantage that he would have over an actual renter would lie in the market appreciation of the home. If its value is increasing at an annual rate of five percent, the homeowner would tend to believe that he is gaining $4,000 in the first year, reducing his previously calculated net cost to $3,300 for the year. So he would be comparing that net cost figure to what he would otherwise pay for renting a home or an apartment.

At this time we have disregarded the loss of earnings on the increased value of the home. That should be calculated also. My illustration should give you a different view from one you might have taken in the past of the cost of owning a home. Using this basic information as a guideline, let's see what happens if one has invested in ownership of an apartment building.


The apartment-building owner has fixed expenses, such as mortgage payments, maintenance, insurance, and management fees. His rental income is the variable. He would need to have enough income from rents to cover his fixed expenses, and, if that were the case, he would have to capitalize the amount of equity he has in the building, that is, the difference between his mortgage and the market value of the building. If it cost him $4 million and has a $4 million net market value, and he had invested $1 million cash in the building, assuming a $3 million mortgage, he would be showing a negative return of $80,000 per year, based on an eight-percent use-of-money factor. This figure is reduced with commercial property, however, since the owner can depreciate his building. Should the allowable depreciation expense be $160,000 in the year illustrated, and he was in a 50-percent tax bracket for purposes of the $160,000 depreciation writeoff, he would save in taxes an amount that would offset his foregone earnings on the equity tied up in the building.

For the moment, we will assume that he is running an occupancy rate of 83 percent. Obviously, if he increases that occupancy then there is a net cash flow to the owner. He would compare this to the amount of equity tied up in the building to see what kind of a return he is getting on his investment. If that excess cash flow above all expenses and payments is $80,000 per year, he would be receiving an eight-percent cash-on-cash return that would be sheltered, as the owner would have the offsetting depreciation of $160,000 mentioned above. He would have $80,000 in excess expenses and, in a 50-percent tax bracket, his tax savings on that amount added to his cash-on-cash return would be giving him the equivalent of a 12-percent net after-tax return on his equity cash. The leverage on this hypothetical case, as you can see, is excellent.


Assuming the investor can maintain an average 95-percent occupancy, he would continue to have such a return, but it would diminish somewhat, since depreciation on the building would be declining and he would be taxed on that portion of the income not sheltered. In fact, the cash flow in excess of the rents would ultimately be taxable income. Should price inflation continue, the owner would have increasing costs, taxes, insurance, and maintenance. He would also (except in New York City!) be able to increase his rental income. If he can raise it above the increased expense factor, then he would be augmenting his cash-on-cash return, that is, assuming the building still had a market value equal to the price he paid for the property. He would also have an estimated mortgage reduction running at an average annual rate of four percent of the the original mortgage.

This illustration might seem like an oversimplification. The intent was only to point out some of the basic elements of tax-sheltered investments. The details of such a real estate venture are far more complicated, particularly when it comes to tax writeoffs generated from such items as prepaid interest and noncompetition, loan procurement, general partner, and prepaid penalty fees.

It is my personal view that a taxpayer who files a joint return and has income such that he is in the 50-percent bracket should shelter to the extent that he ends up paying no more than $6,000 a year in taxes. It is possible to do this using the leverage of tax dollars only, that is, dollars that he would have paid in taxes. The investor who manages his own money in tax-incentive investments can do a better job of handling that money than can the government and he is thereby contributing more to the economic benefit of our system as a whole.


To evaluate what Congress has in store for tax-sheltered investments and what possible course the laws of our land will take, one must examine the historical background—Why are we where we are today?

Let's go back to the 1930's. You may recall that individual income was taxed at the rate of three percent and corporate taxes started at four percent. Then President Roosevelt embarked on a program of social reform, and in order to pay for this, it was necessary to increase taxes. We saw taxes on individual income eventually increased up to a rate of 91 percent for some persons. We came to see corporate taxes in excess of 50 percent, in some cases as high as 70 percent when taxes on excess profits are considered. We also saw estate taxes, as well as gift taxes, taking a considerable portion of assets. Only the superrich who formed tax-exempt foundations were able to preserve their wealth.

By the time the 1960's rolled around, the Federal budget was in the vicinity of $100 billion per year. At that time a study ascertained that if all the people in the United States with earnings over $25,000 per year were taxed on that excess at a rate of 100 percent, it would only generate an additional $7 billion per year, which, even at that time, would only take care of 10 days of social spending!

John F. Kennedy sloganized his great society with "Let's get things going," and the Federal government launched into massive social programs funded by deficit spending. This was the second stage of the welfare state. We had taxed away the income of the rich to redistribute it to the poor, and now we embarked upon deficit spending—it would be unpopular to tax the public to accomplish these goals. In fact, during the 1960's we had tax cuts while the Federal budget increased substantially. The obvious result was monetary inflation, which brought about price inflation. Liberal Congressmen, social tinkerers one and all, turned their attention to the next area of attack. To increase the government's take, they advocated tax reform that would reduce the extent of tax-sheltered investments. So we ended up with the Tax Reform Bill of 1969, the first attempt to eliminate tax-incentive investments.

Free market advocates breathed a guarded sigh of relief when Mr. Nixon was elected. It was hoped that, as a conservative, he would pay attention to the country's capital formation needs and realize that tax-incentive investments would continue to be, as they had proven in the past, the most effective way to raise capital. As history has shown us, however, the Nixon era illustrated that he too believed in deficit spending, for during his tenure he proclaimed himself a "Keynesian." The results of this thinking are obvious. Both monetary and price inflation continue to grow, accepted now as a fact of life.


With the huge deficits our government has created, the pressure is again on Congress to attempt to cover these deficits by taxation. It doesn't matter that taxing the general public is politically unpopular—the majority of these politicians still advocate social programs to redistribute wealth. This leaves them primarily one area to attack. To accomplish their goals it is necessary to further tax the productive side of the economy. Thus we have new proposals for radical tax-loophole reform.

The House Ways and Means Committee completed its tax proposals at the end of 1975 and delivered to the House in December a bill that fills 674 pages of small print. The Congressmen had this bill in their hands less than one and a half days when they voted to adopt it! It was forwarded to the Senate, where it was taken up on March 17 by a committee headed by Senator Hugh Long. The Senate is not expected to vote on any tax-reform bill this year. The emergency tax-cut bill covering individual taxpayers that has been extended for six months will probably be extended again, perhaps through 1977, and it won't be until 1977 that we will have the final tax-reform bill.

Information obtained from the Joint Committee indicates that tax-incentive investments will survive, as there is still enough sober thinking to engender moderation. The radical bill that has been proposed would go a long way toward destroying capital formation, which would have serious repercussions in the economy and could even trigger the most catastrophic depression the country has ever seen. The unions have become aware of the possible impact, and moderate liberals are even changing their previous positions as they realize that destruction of capital formation funds would create massive unemployment.

I predict that we will continue to have tax-incentive investments that will be worthy of the consideration of investors in high tax brackets. I believe they will continue to find suitable tax-incentive investments to fit into their financial planning.

Richard McIntyre attended the University of Southern California and the University of Washington. He is currently the chairman of Economic Research Analysts, which specializes in gold stocks and tax-sheltered investments. He is also the president of companies operating in insurance, mortgage, and real estate, and is a lecturer and speaker.