FTax SM_ch12_p001-022

2011 Federal Taxation (with H&R BLOCK At Home(TM) Tax Preparation Software CD-ROM)

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Unformatted text preview: * C HAPTER T WELVE * DEDUCTIONS FOR CERTAIN INVESTMENT EXPENSES AND LOSSES SOLUTIONS TO PROBLEM MATERIALS DISCUSSION QUESTIONS 12-1 a. Prior to 1986, properly structured investments such as Neptune III provided taxpayers with a legitimate opportunity to save taxes relative to conventional investments. A typical tax shelter produced three basic tax benefits: (1) tax deferral; (2) permanent tax reduction; and (3) conversion of ordinary income into favorable capital gain. Some tax shelters offered all three benefits, while others did not. (See pp. 12-1 through 12-6.) Vehicle. In order to make any tax saving opportunities available to investors, tax shelters must be properly structured. To accomplish this, most tax shelters are organized as limited partnerships in which the investors are limited partners. From a tax perspective, the limited partnership form is the perfect vehicle because it is not a separate taxable entity but rather a conduit. Consequently, all tax benefits derived from the venture flow directly through to the limited partners for their personal use. For example, ordinary losses produced by the partnership flow through to the partners as do tax credits and capital gains. The limited partnership also provides nontax benefits. The limited partnership form provides the investors with a form of limited liability, reducing the risk of their investment. For the most part, the investors, as limited partners, are liable only to the extent of their original investment (although some partnerships require additional contributions beyond the initial contribution). S corporations are sometimes used as tax shelter vehicles since they are also conduit entitles and provide investors with limited liability. Their usage is restricted, however, because the maximum number of investors (i.e., shareholders) cannot exceed 35. Deferral of the Tax. The objective of virtually all tax shelters is to defer the payment of taxes that otherwise would be due currently. This goal is usually accomplished by the creation of initial tax losses that approach, or in many cases, exceed the investor’s initial cash investment, particularly with real estate where leverage can be used. For example, Neptune III might be formed by ten investors, each contributing $10,000 for a total of $100,000. The partnership would subsequently borrow $900,000 and use the total $1 million to build the office building. If depreciation in the first year was $150,000, each investor would be entitled to a deduction of $15,000 even though the actual amount invested was only $10,000. By using leverage, a taxpayer could multiply his or her deductions far beyond the amount invested, and especially in cases when nonrecourse debt was used far beyond the amount the investor actually had at risk. The result of this strategy was to produce expenses in the early years of the operation that exceeded income, producing a tax loss. More importantly, under the right circumstances, the investors did not really suffer a...
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