14.  Tax Shelter and Capital Gains Taxes

Take a look at the following excerpts from recent syn­dicate brochures. (The names of the accountants whose opinions are quoted are omitted.)

Accountant estimates that the first five years an av­erage of 63% of the annual cash distributions will not be reportable for federal income tax purposes. For the first 10 years, the amount not reportable will average about 53% per year.

The accountants have estimated that an average of approximately 72% of the distribution will not be reportable as taxable income for the first five years. . . .

Other brochures mention the word tax shelter. Know the language. No one will say that you do not have to pay any taxes at all. They say that on a portion of your distribution you do not have to pay income taxes. They leave it to your imagination to figure out that you may have to pay capital gains taxes. When you read the words tax shelter, bear in mind that you have to pay taxes when you leave that shelter.

This is how it works. You buy a syndicate participation for $5,000. Every year for ten years you receive $500, as­suming that the distribution amounts to 10%. At the end of 10 years, you will have received $5,000. Let us assume that 60% of the moneys received were not reportable for federal income taxes. At the end of 10 years, you want to sell your unit. You find someone who will pay you $5,000.

You may think that since you paid $5,000 and that since you sell for $5,000, you did not make a profit and do not have to pay taxes. Uncle Sam does not agree with you. He will tell you that you received 60% of your in­vestment, that is $3,000 back during the last ten years. You may call it depreciation, return of capital, or what­ever you like. But it was not income. That's why you did not have to pay income taxes on it. But since you re­ceived $3,000 of your investment back, free of income taxes, Uncle Sam argues that for tax purposes you have only $2,000 of tax base left. When you sell for $5,000, you have realized a gain on your investment amounting to $3,000, and you have to pay capital gains tax.

Uncle Sam waited patiently for 10 years. Yet ultimately he collected a tax. Nevertheless, the tax shelter does something for you. You do get some very substantial benefits. First, for 10 years you did not pay any taxes on a large portion of your yearly distributions. During these 10 years you had the use of the money which you would have had to pay out in taxes. At the end of 10 years, you do pay a capital gains tax but only at half the rates of your ordinary income tax bill and in no case more than 25%, even if you are in the highest tax bracket. So if you are in the 40% income tax bracket, your capital gains tax would be only 20%. If you are in the 30% income tax bracket, your capital gains tax will be only 15%.

Tax shelter does not mean that you won't have to pay taxes at all. It means that part of the taxes are deferred for a long period, usually until you sell your investment. It also means that you will pay taxes at half your ordinary income tax rates—a substantial saving.

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