Boston — ``For the last 10 years, people have invested in real estate for the wrong reason -- tax breaks.'' That, says James McKellar, director of the Center for Real Estate Development at the Massachusetts Institute of Technology, is a key reason real estate was a primary target in the Tax Reform Act of 1986. Because of the wide variety of tax breaks in previous laws, ``We've built offices and hotels far in excess of the need,'' he says.
For this reason, real estate investments are going to have to change the way they are structured, change their emphasis from stressing tax breaks to featuring income, or go out of business.
While Congress did not outlaw ownership of real estate for investment, it did force some changes that other tax shelters, such as oil and gas exploration and cattle breeding, have had to learn to live with.
``Through the late 1970s, many other tax shelters were eliminated,'' recalls Elliot Lesser, partner in charge of real estate practice at Laventhol & Horwath, an accounting firm. ``Before that, people could take losses well in excess of any money actually invested.'' While previous Congresses were able to eliminate most of these write-offs in other shelters, the real estate lobby kept its industry largely untouched -- until this year.
``The real estate lobby may have been asleep at the switch,'' says David Millstein, national real estate industry chairman at Coopers & Lybrand, another accounting firm.
On the other hand, Mr. Millstein adds, there may not have been much the real estate lobby could have done. ``This is the first time I can recall that both sides [Republicans and Democrats] were pushing to see how much they could do to the tax laws.'' In that environment, he maintains, even real estate investing, once considered to be as much a part of America as settling the West and staking a claim on a piece of rangeland, was unable to stand up to the reformers.
But Congress did not destroy all real estate investments. And it did not take away tax breaks for all real estate ownership. It just changed some of the rules of the real estate game.
And while some investors will suffer short-term losses, most experts believe that in the long run the new rules will result in real estate investments that are just that: investments, not tax dodges. They also believe the changes will slow the massive overbuilding of office complexes, hotels, and shopping malls.
One of the new rules changed the so-called ``passive loss'' provision. Passive gains or losses come from activities in which the investor does not materially participate. In most cases, this means limited partnerships. Non-passive, or active, income would include salary, interest, dividends, capital gains, and business in which the investor materially participates.
Under current law, passive losses can be used to offset active income. In some cases, these losses can be counted against active income more than once, for 2-to-1 or 3-to-1 write-offs.
Under the new tax law, this all changes. Starting in 1987, 35 percent of passive losses against active income will be denied, and by 1991, no passive losses can be applied against active income.
Also, losses from rental property will now be considered passive. So landlords with incomes above $150,000 will not be able to offset any passive losses, including building expenses, against active income. Taxpayers earning less than $100,000 would be allowed to offset up to $25,000 in real estate losses against active income, as long as the investor materially participates in the property. This will help someone, for example, who owns a two-family house and rents out part of it. But the exemption is gradually reduced for those earning between $100,000 and $150,000.
The other major change extends the depreciation period for all commercial real property from 19 years to 31 years, and the depreciation for rental property is extended to 27 years. This means that the fraction of a property's ``useful life'' that can be deducted each year is much smaller.
``Depreciation is pretty much gonzo,'' observed Thomas Donnelly, senior vice-president of Billings & Co., a development subsidiary of the Advest Group, a Hartford, Conn., brokerage.
The changes in depreciation schedules and the eventual elimination of the passive-loss provision mean that from now on, the quality and return on the investment will be almost the only reasons for selecting a real estate investment. Tax breaks will mean very little.
``It's a big change that they [the real estate industry] will get used to,'' says Claire Longden, a financial planner with Butcher & Singer, a brokerage. ``Partnerships were being formed merely for the tax advantages.''
``I see a downturn in construction as a result'' of existing tax laws, Mr. Lesser adds. ``Many areas are overbuilt. Now, demand will have a chance to catch up with supply.''
The oversupply of office buildings, for instance, is not just limited to depresed oil-patch cities like Houston; Tulsa, Okla.; and Denver, Dr. McKellar says. Even in the Boston area, it's possible that office vacancy rates could go as high as 30 percent next year along parts of the Route 128 area, which has been the headquarters of New England's high-tech boom.
``Speculation has been going on everywhere,'' he says. ``Syndication is out the window. The whole investment picture will definitely change.'' While there has been a lot of overbuilding, particularly in offices and hotels, there will always be a need for the right kind of new building in the right location, he adds.
Much of the oversupply came about because of passive-loss rules which allowed as much as a 3-to-1 write-off of losses against other income. Most of these high-write-off deals were private partnerships, which were sold or syndicated privately and were not registered with the Securities and Exchange Commission. For them, tax breaks were the main attraction. Tax reform will probably close that show, because investors will no longer be able to deduct passive losses in excess of their passive income.
Public partnerships, on the other hand, have been largely income-oriented anyway, and should survive. In fact, while you may not see ads for income programs during the Super Bowl, brokers and financial planners will be pushing them as hard as any carmaker hawking the latest Sleekmobile.
Not only will these deals be more attractive to people who want income-oriented investments, they will also be necessary for investors who can't get out of existing programs with high losses. These investors will need the additional income to offset those losses. Otherwise, the losses are just losses.
To find the right investment among the crowd, stick with established general partners or sponsors who have been in business for several years. Using the top names in syndication doesn't guarantee success, but it helps.
Among the large public syndicators frequently mentioned by real estate experts are JMB Realty, Consolidated Capital, HCW Inc., Trammell Crow, Spalding & Slye, and Olympia & York.
These are among the largest syndicators, but your broker or financial planner will probably have dozens of others, including several reputable offers from smaller partnerships.
``There are certainly many other fine smaller firms,'' McKellar says. ``One doesn't need size. But one certainly needs a good reputation. It's not hard to find out about reputation, but you have to do some homework.''
For now, stick with properties that will generate immediate cash distributions. There should be enough income from rents to cover all expenses and give investors a respectable payout. Currently, a good yield is about 9 or 10 percent.
Income projections should not, however, depend on big rent increases to make up for lost tax breaks. Tenants will absorb some rent increases, but if those hikes go much beyond inflation, they will look for other landlords or find ways to buy their own offices.
The same thing probably applies to apartments: With mortgage rates stil fairly low and home prices softening in many part of the United States, landlords will have to be careful about boosting rents on their apartments.
``Everyone says rents will go up,'' observes Ralph Presutti, a financial planner with Advest Inc., a brokerage. ``I disagree with that. I look at the supply/demand situation with rental property and I see an oversupply. Also, more single-family units have been built and there are just more positives to buying your own home or condo.''
For now, the best advice seems to be to wait. A flood of investment opportunities will be offered in the next few months, and time may be one of the best ways to sift the bad ones from the good.
``This has been the easiest three or four months I've ever had,'' says Vernon L. Woodrum, a financial planner in Charlotte, N.C. ``I just sit back and tell people not to do anything.''
``I'd sit on my hands for three, four, or five months,'' Mr. Presutti recommends. After the bad deals -- the ones dependent on tax write-offs or unrealistic rent projections, or are in a poor location -- are sifted out, you'll be able to get the others at a good price. ``I'm not saying you shouldn't buy,'' Presutti says. ``I'm just saying maybe you should wait.''