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AN EMPIRICAL EXAMINATION OF SELECTED FEDERAL
TAX PROVISIONS ENACTED TO AID IN THE

SYNDICATION OF GOVERNMENT-ASSISTED HOUSING

BY

Brian Lynn Laverty

A DISSERTATION

Submitted to
Michigan State University
in partial fulfillment of the requirements
for the degree of

DOCTOR OF PHILOSOPHY

Department of Accounting

1984

’1‘

.l—75 ftJ‘; L

ABSTRACT
AN EMPIRICAL EXAMINATION OF SELECTED FEDERAL

TAX PROVISIONS ENACTED TO AID IN THE
SYNDICATION OF GOVERNMENT-ASSISTED HOUSING

BY

Brian Lynn Laverty

This study assesses the impact of various income tax
provisions on the incentive to invest in newly constructed
government-assisted housing syndicated in the limited
partnership form. The study focuses on provisions enacted
by the Economic Recovery Tax Act of 1981. Amendments made
by the Tax Reform Act of 1976 and the Revenue Act of 1978
are also examined wherever appropriate.

For each pre-l976 investment evaluated, 162 investor
profiles were produced by allowing three possible values for
the marginal tax rate, personal service income as a
percentage of taxable income, investment holding period, and
the selling price of the property. Furthermore, two levels
of tax preference items were assumed for both the maximum
and the add-on minimum tax.

For each 1981 Section 8 project evaluated, 486 investor
profiles resulted from: (1) eliminating the variable for
personal service income as a percentage of taxable income,
and.(2) adding three legislation variables and their

interactions.

The study reveals that the pre-1976 investment
prospectuses significantly overstate the tax benefits
available to the investors even with an analysis which
assumes that the pre-1976 tax law remained in effect. All
of the Acts examined are shown to have had a significant
negative impact on investment return from low-income housing
investments which preceded their enactment.

While the Economic Recovery Tax Act of 1981
significantly increased the cost recovery deductions for
Section 8 housing and reduced the net capital gain tax, a
present value analysis indicates that the reduction in the
maximum marginal tax rate to 50 percent and the increase in
the level at which income is subject to those rates produces
a negative impact on investor returns. Alternatively, the
provisions specifically enacted to favor low-income housing

are shown to have a positive effect on investment return.

This dissertation is dedicated with all my love to Dorothy

J. Laverty, Martha M. Studnicka, and James Thomas Laverty.

ii

TABLE OF CONTENTS

LI ST OF TABLES O O O O O O O O O O O O O O O O O O 0

LIST OF FIGURES O O O O O O O O 0 O O O O O O O O 0

Chapter

I.

II.

III.

IV.

INTRODUCTION 0 O O O O O O O O O O O O O O O

The Douglas and Kaiser Commissions . . . .
Incentives Provided by Tax Law . . . . . .
Tax Legislation Affecting Low-Income
Housing . . . . . . . . . . . . . . .
Purpose of the Study . . . .
Research Methodology . . . .
Limitations of the Study . .
Significance of the Study .

AN OVERVIEW OF SECTION 8 HOUSING AND THE

A

TAX LAW AS IT AFFECTS INVESTMENTS IN
LOW-INCOME HOUSING . . . . . . . . . . . .

HUD Section 8 Program . . . . . . . . . .
Michigan State Housing Development
Authority (MSHDA) . . . . . . . . . .
A Historical Review of Tax Laws Affecting
Low-Income Housing . . . . . . . . .
Risk . . . . . . . . . . . . . . . . . . .

REVIEW OF RELATED STUDIES . . . . . . . .
Limitations of Previous Studies . . . . .

Review of Previous Studies . . . . . . . .
summary 0 O O O I O O O I O O O O O O O 0

RESEARCH METHODOLOGY AND DESIGN . . . . . .

Methodology . . . . . . . . . . . . .
Formulating the Problem . . . . . . . .
Construction of a Computer Model

Representative of the System

Under Study . . . . . . . . . . . . .
Model Validation . . . . . . . . . . . . .
Design of the Study . . . . . . . . . . .
Model Description . . . . . . . . . . . .

iv

Page
vi

vii

AL.)

11
12
14
16

19
20
26

30
45

53

53
54
64

66

66
67

69
7O
71
87

Chapter Page

IV. Description of Input . . . . . . . . . . . . 88
Description of Output . . . . . . . . . . . 98

V. RESEARCH RESULTS AND CONCLUSION . . . . . . . 102

Projected Versus Actual Results and the

Impact of Post-1975 Tax Reforms . . . . 103
The Effect of the ERTA of 1981 and

Relevant Legislation Variables . . . . 127
Summary . . . . . . . . . . . . . . . . . . 148
Conclusion . . . . . . . . . . . . . . . . . 155

BIBLIOGRAPHY O O O O O O O O O O O O O O O O O O O I O 159

Summary
Pre-TRA

Summary
Pre-TRA

Summary
Pre-TRA

Summary
Pre-TRA

Summary
Pre-TRA

Summary
Pre-TRA

Summary

Summary

of
of

of
of

of
of

of
of

of
of

of
of

of
of

LIST OF TABLES

Overall Results
1976 Section 8 Housing . . .

Impact by Marginal Tax Rate
1976 Section 8 Housing . . .

Percentage of PSI Impact
1976 Section 8 Housing . . .

Minimum Tax Impact
1976 Section 8 Housing . . .

Impact by Selling Price
1976 Section 8 Housing . . .

Impact by Holding Period
1976 Section 8 Housing . . .

Payback Results (in quarters)

Average Rate of Return Results

(in percent) . . . . . . . . . . . . . .

Summary of Profitability Index Results .

vi

Page

105

108

112

116

120

124

130

135

141

LIST OF FIGURES

Applicable Recapture Percentages
For Section 1250 Property . . . . .

ACRS Percentages for All Real Estate
(Except Low-Income Housing) . . . .

ACRS Percentages for Low-Income Housing
Summary of Variables . . . . . . . . .
Program Flowchart . . . . . . . . . . .
Input Form . . . . . . . . . . . . . .
Main Program and Subroutines . . . . .

Example of Output . . . . . . . . . . .

vii

Page

37

80
81
85
89
91
96

100

CHAPTER I

INTRODUCTION

The federal government became a significant factor in
the housing market in 1934. In that year, the Housing Act
of 1934 established the Federal Housing Administration and
mortgage insurance programs for single and multifamily
houses; insured certain Savings and Loan Association
deposits; and created national mortgage associations to
provide a secondary market for home mortgages. The
magnitude of the federal government's presence some 40 years
later is reflected in a Department of Housing and Urban
Development (HUD) statement that "today there is not a
significant aspect of the vast, diverse and complex housing
market that is not affected by government action in one form
or another.”-

In 1949 Congress established "the goal of a decent home
and suitable living environment for every American family."2
The housing acts of 1949, 1954, 1961, 1964, 1965, 1968, and
1974 attest to the difficulties and frustrations Congress

has encountered in attempting to meet this goal. A

"Statement of the Council of State Housing Agencies" in 1980

2
Hearings before the House Ways and Means Committee further
evidences the difficulty of meeting this goal.

Low and moderate income multifamily rental housing
is in seriously short supply. According to a
recent National Association of Home Builders study
"Rental Housing in the 1980's", by 1990 the United
States is predicted to have 30 million rental
households, 3 million more than at present.
Current low vacancy rates are projected to prevail
throughout the mid 80's and the demand for rental
housing in the next decade will be concentrated in
the multifamily sector.umThese lxnv vacancy rates,
combined with a dramatic growth in rental
households and the current low production of low-
income housing all add up to a rental housing
crisis which is rapidly approaching.

To accommodate demand in the 80's, the annual
housing starts for rental apartments must average
400,000 to 450,000 units a year. To sustain such
a volume, the subsidized housing sector must
contribute 150,000 to 175,000 units a year, up to
45 percent of the total production, and that
without sufficient tax incentives, the need for
more extensive subsidization will prevail.
(Emphasis added.)

 

 

The lack of success in realizing the goal of a decent
home for every American family was highlighted in 1968 and
again in 1969 by two study groups: The National Commission
on Urban Problems (also known as the Douglas Commission
after its chairman, Senator Paul Douglas) and The
Presidentds Commission on Urban Housing (also known as the
Kaiser Commission after its chairman, Edward E. Kaiser). In
1977, the Congressional Budget Office (CBO) undertook a
study that focused on the most effective means of
encouraging investment in low- and moderate-income rental
housing. Another CBO study, in 1978, attempted to provide

Congress "with an overview of the wide range of current

federal housing programs and housing—related activities, and

an understanding of recurring housing policy issues."4

The Douglas and Kaiser Commissions
The Douglas Commission (1968) studied housing in

addition to other urban problems. The primary housing-
related conclusion reached by this commission was "that
special tax preferences should not be relied upon as the
sole or even the primary instrument to deal with urban
housing problemsflS However, the Commission went on to
recommend:

1. a change in the tax law "to provide materially
more favorable treatment for investment in new
residential construction (including major
rehabilitation) than in other forms of real
estate investmentufl‘

2. "".prompt revision of the Federal income tax
laws to provide increased incentives for
investment in low- and moderate-income housing,
relative to other real estate investment, where
such housing is governmentally subsidized and
involves a legal limit upon the allowable
return on investor's equity capital."

3. "."the Internal Revenue Code be amended to
provide specific incentives for adequate
maintenance and rehabilitation of rental
residential property by allowing, within
appropriate limits, for especially generous tax
treatment of investor-owner's expenditures for
these purposes with respect to structures of
more than some specified age..."6

The Kaiser Commission (1969) concluded that many of the
then current income tax provisions arbitrarily discouraged
real estate investment. The recommendations of this

commission also relied heavily upon tax incentives as a

4
means of encouraging the construction of low- and moderate-

income housing.

Incentives Provided by Tax Law

By enacting the Housing and Urban Development Act of
1968, Congress made a conscious decision to use the federal
tax laws in conjunction with direct housing subsidies to
induce private developers to produce more residential rental
housing, particularly for families of low- and moderate—
incomes. That decision, which essentially adopted the
recommendation of the Kaiser Commission, was followed by the
enactment of incentive provisions in the Tax Reform Act of
1969. Those provisions favored the construction of
residential rental property, particularly low- and moderate-
income housing, and reduced the tax benefits favoring the
construction of other types of real estate. The most
notable of these provisions permitted double declining-
balance and sum-of-the-year‘s digitds depreciation for new
residential property, but proscribed their use for non-
residential real estate. Another provision permitted a gain
from the sale of low-income residential property to qualify
as a long-term capital gain after a holding period
substantially shorter than that for other real property.

Many of the incentive provisions in the tax law
resemble direct government expenditures. For this reason,
they have become known as "tax expenditures". In recent

years these tax expenditures have become one of the major

5
ways in which the federal government allocates its resources
and affects private-sector decisions. In 1967, the first
year for which an official tax expenditure budget was
compiled, there were 50 items with a total revenue loss of
$36.6 billion--20.5 percent of total federal direct outlays
in that year and 4.4 percent of the gross national product.
By fiscal year 1981, tax expenditures had grown to a total
of $228.6 billion--34.6 percent of outlays and 8.0 percent
of GNP. A recent tax expenditure budget included 104 items
totaling $266.3 billion for fiscal year 1982. The Economic
Recovery Tax Act of 1981 (ERTA) added eight new tax
expenditures, expanded 22, and reduced two others.

As a result of the incentive provisions, the federal
government exerts more influence through tax expenditures
than it does through direct spending in many areas. For
example, current tax expenditures for general purpose fiscal
assistance are greater than direct federal outlays, and tax
expenditures for housing exceed outlays by more than four to
one. Tax expenditures add to the federal deficit in the
same manner as direct spending programs. They allocate
resources and provide incentives and benefits as do spending

programs.

Low Income Housing Syndication as a_"Tax Shelter"

 

Tax shelters are not entirely a deliberate
Congressional creation. They have evolved from the use of
various tax provisions in ways often not foreseen. However,

their continued existence implies that Congress now intends

to subsidize those activities not expressly considered when
enacting the tax provision(s).

A tax shelter is an “investment" that provides
investors with a tax deferral in return for assuming the
economic and financial risks of certain activities. In some
cases it reflects a specific Congressional policy decision
to use tax incentives to direct private capital into certain
segments of the economy. An excellent example is the use of
tax incentives to encourage investment in government-
assisted housing.

The essence of a tax shelter is to shield current
income from taxation by offsetting it with deductions
attributable to operations. Much of the loss is artificial,
created by bunching and accelerating deductible expenses in
the initial years of shelter operations rather than matching
those expenses with the revenues they produce. The investor
is thus able to postpone the payment of tax on any economic
income from the "shelter" as well as income from other
sources. This tax deferral represents a savings to the
investor in that he has the use of his funds for a longer
period of time, a situation often equated to an interest-
free loan. Tax deferral may be relatively permanent where
the investor invests in a new shelter when an earlier
shelter "burns out", iJL, produces taxable income rather
than tax losses.

Another significant aspect of tax shelters is the

potential for the conversion of ordinary income into long-

term capital gain. When an investor deducts losses
attributable to Operations, the deduction offsets his
ordinary income. However, when an investor sells his
investment, part or all of any resulting gain may be
recognized as long-term capital gain and qualify for
favorable tax treatment.

A real estate tax shelter, in its most perfect form,
combines a current tax loss with a positive cash flow. To
allow investors to benefit from the tax loss, the shelter is
usually organized as a partnership. This is advantageous
for several reasons, foremost of which are the availability
of partnership liabilities to increase the adjusted basis of
the partners' interests and the pass-through of losses to
the partners. Furthermore, the shelter is usually
structured as a limited partnership, to allow investors the

added feature of limited legal liability.

Tax Legislation Affecting Low-Income Housing

The Tax Reform Act g: 1976 (TRA of 1976)

 

 

The proliferation of tax shelters in the 1970's led to
widespread discontent with perceived inequities in the tax
law. Congress decided changes were necessary to reduce
_ excessive tax deferrals provided by tax shelters and to
limit the opportunity to convert ordinary income into
potential long-term capital gain. Congress also resolved
that high-income individuals should not be able to

completely escape their income tax liability.

This led to two distinct approaches to curb certain
abuses of the law. The first approach aimed at reducing the
benefits of the deferral and conversion features of a tax
shelter. However, the preferential treatment of low-income
housing was continued. One of the TRA of 1976's most
significant limitations on real estate investments, the
disallowance of current deductions for construction period
interest and taxes, did not apply to low-income housing for
the five year period through 1981. The Act also expanded
the depreciation recapture provisions to prevent the
conversion of ordinary income into potential long-term
capital gain. Subject to a holding period requirement, low-
income housing was also exempted from this provision.

The second approach to curbing abuses took the form of
bolstering the add-on minimum tax and reducing the benefits
of the maximum tax for taxpayers with "tax preference
income." The minimum tax (which was enacted so that
taxpayers with large amounts of preference income could not
entirely avoid taxation) was tightened and the rate was
increased from 10 to 15 percent. The change in the maximum
tax provisions extended the 50 percent maximum tax rate to
personal service income, but provided that eligible income

would be reduced by all tax preference income.

Congress enacted the RA of 1978 with the purpose of

stimulating "consumer and investment spending in order to

9
increase economic growth.w7 ‘The Act provided for a major
reduction in the income tax on net capital gains.8
Specifically, the Act increased the percentage of a net
capital gain deductible from gross income from 50 to 60
percent. The Act also removed this deduction from the list
of tax preferences for both add-on minimum and maximum tax
purposes.

To ensure that this tax reduction did not result in
high-income taxpayers paying little or no income tax, the
Act created an "alternative minimum taxJ' The 60 percent
capital gain deduction was included in determining the
taxpayer's alternative minimum tax (unless it arose through
the sale of the taxpayer‘s personal residence), which was
payable when it exceeded the sum of the taxpayer‘s regular

income tax liability and the add-on minimum tax.

The Economic Recovery Tax Act (ERTA) g; 1281

In response to declining productivity growth and a
perceived public outcry favoring tax cuts, President Reagan
proposed a package of tax cuts in 1981. Congress responded
by enacting the ERTA of 1981 which substantially revised the
federal income tax treatment of depreciation (now known as
"cost recovery“). The newly enacted Accelerated Cost
Recovery System (ACRS) generally provides a much faster
”write-off" for real estate investments. The stated purpose
of the ACRS is to "provide incentives for investment
spending and contribute immediately to cash flow for the

financing of such spending."9

10

Three changes made by the ERTA of 1981 were important
preferential provisions intended to aid low- and moderate-
income housing. The first of these is the availability of
200 percent declining balance cost recovery for low-income
housing (while other real property eligible for cost
recovery is limited to a maximum of 175 percent declining
balance). A second major differential is the permanent
exemption of low-income housing from the requirement to
capitalize and amortize construction period interest and
taxes. The House Ways and Means Committee Report provides
the following rationale for this differential:

To prevent a slow down of construction of low-

income housing, the committee believes it is

necessary to exempt low-income housing from the

rule requiring capitalization and amortization of

construction period interest and taxes.10

A third provision enacted by the ERTA of 1981 was
designed to increase the differential between residential
and commercial real property. This change significantly
increases the amount that must be recaptured as ordinary
income on the sale of commercial real property for which the
optional straight-line ACRS capital recovery method is not
adopted. The existing depreciation recapture differential
between low-income and other residential real property was
left intact.

The ERTA of 1981 also repealed the maximum tax on
personal service income and reduced the tOp individual tax

rate from 70 to 50 percent beginning in 1982. In addition

to eliminating the highest marginal tax rates, this change

11

effectively reduced the highest tax rate on net capital
gains from 28 to 20 percent (from 70 percent of 40 percent
to 50 percent of 40 percent). By decreasing the maximum tax
rate on net capital gains, the ERTA provides an additional

investment incentive.

Purpose of the Study

The objective of this study is to assess the impact of
various income tax provisions on the incentive to invest in
newly constructed government—assisted housing syndicated in
the limited partnership form. The study focuses on
provisions enacted by the ERTA of 1981. Furthermore,
amendments made by the TRA of 1976 and the RA of 1978 are
examined where appropriate. The more specific objectives of
this study are:

1. To determine the extent to which an investor's
expected return from low-income housing
differs from his actual return.

2. To determine the relative impact of the tax
legislation on investment returns earned in
low-income housing syndications by investors
with different characteristics (iJL, marginal
tax rate, investment holding period).

3. To determine the impact of the ERTA on
expected returns for an investment in low-

income housing.

12
4. To investigate the differential impact of the
provisions specifically enacted to provide an
incentive for investment in low-income

housing.

Research Methodology

Two computer programs were developed to assist in this
study. The first program was used to analyze investor
expectations at the time of investment in six early Section
8 housing syndications.1l The investments examined
consisted of government—assisted housing syndications for
which the Michigan State Housing Development Authority
(MSHDA) has a compete history (financial statements through
at least 1980). This sample represents all MSHDA Section 8
housing syndications for which initial closing predates the
TRA of 1976.

This program develops the cash flows generated directly
by these projects through Operation, sale, or refinancing;
and indirectly in the form of tax savings or additional tax
liability. Because this program attempts to measure
expectations for pre-1976 investments, the tax savings or
costs are developed using the law existing prior to the TRA
of 1976. The program also develops several measures of
return as explained below.

A second computer program estimates the return earned
by investors in Section 8 housing utilizing the actual tax

law applicable to each tax year (through the ERTA of 1981).

13
The program develops the cash flows generated directly by
these projects through operation, sale, or refinancing; and
indirectly in the form of tax savings or additional tax
liability. The various measures of return developed by the

program are discussed below.

Measures 2: Return

Several measures of return are calculated for each
investor profile. A review of the real estate and
investment literature suggested several return measures that
are used in practice. The output of this study provides the
following: the internal rate of return, the payback period,
the present value of cash flows over the initial cash
investment (a profitability index), and the average rate of

return.

Variables

 

The investor profiles are created by incorporating
multiple values for three taxpayer, two investment, and
three legislation variables. The first of the three
taxpayer variables is the marginal tax rate. This study
evaluates each of the pre-1982 investor profiles at three
levels--70 percent, 60 percent, and 50 percent. Since the
highest marginal tax bracket for 1982 and later years is 50
percent, this variable remains constant for the reformulated
(post-1981) projections.

The second taxpayer variable is the percentage of

taxable income realized in the form of personal service

14
income (PSI). This study evaluates each of the pre-1982
investor profiles at three 1evels--90, 50, and 20 percent
PSI. Since the maximum tax has been repealed for 1982 and
later years, this variable remains constant for the
reformulated (post-1981) projections.

The last taxpayer variable is the amount of the
investor‘s tax preference items. This study evaluates each
of the investor profiles at two levels: UJ all the
preferences from an investment in the syndication are
subject to the add-on minimum tax, and (2) assuming the
investor‘s tax preferences before his investment in the
particular low-income housing syndication were average for
someone of his income level (based on the latest IRS
statistics).

The first of the two investment variables utilized in
this study is the investor‘s holding period. Three holding
periods are evaluated for each investor profile-~nine, 12,
and 15 years. The second investment variable is the selling
price of the investment. This study evaluates each of the
investor profiles at three possible selling prices--three
percent compounded annual growth, no appreciation or loss in
value, and the mortgage balance at the end of each of the

holding periods.

Limitations of the Study
Investment decisions are based on an analysis of at

least two factors, return and risk. The difficulty

15
associated with measuring risk in a real estate investment
is discussed in Chapter II. This study does not
specifically incorporate any measures of risk. However,
intuition suggests that, to the extent the TRA of 1976
reduced early year losses, the risk was increased.
Alternatively, to the extent that the RA of 1978 increased
the return on a sale of real estate and the ERTA of 1981
increased the early year losses, it would appear to decrease
the risk of these investments.

A second limitation of this study is one that attends
any simulation project. The complexities of the real world
can never be perfectly duplicated, nor can every possible
combination of variables be considered. Therefore, the
generalizability of the results may be limited. A thorough
review of the relevant literature, interviews with
individuals knowledgeable in real estate matters, and an
analysis of dozens of actual real estate limited partnership
prospectuses were performed to ascertain the validity of the
model. The use of a number of data sets in this model
increases the generalizability of the results.

Several less significant limitations should be noted.
No analysis was undertaken to determine the effect of the
tax law changes on the attractiveness of other investments
Une., bonds and stocks). Additionally, consideration of
the effects of the various tax changes on supply and demand,
shifts in relative tax burdens, and changes in rental rates

were not considered in this study.

16

Significance of the Study

The primary significance of this study is to provide a
framework for future policymaking, assuming that Congress
wil 1 continue to use the tax system to encourage (or
discourage) various segments of the real estate sector.

The first set of objectives in this study provides
policymakers with some empirical evidence regarding the
changes made by the TRA of 1976, the RA of 1978, and ERTA of
1981 on investments in low-income housing syndications that
preceded these changes. If the changes have retroactively
and significantly affected an investor's return, it may
indicate a lack of certainty (regarding the tax aspects)
that may discourage rather than encourage investment. If
the changes have not materially affected investment return,
then the legislation has created a myriad of complex
provisions which, if eliminated, would allow investors to
more readily evaluate available incentives.

A second set of objectives addresses the impact of the
ERTA of 1981 on low-income housing investments. The
decrease in the maximum marginal tax rate from 70 percent to
50 percent beginning in 1982 wil 1 act to offset the
beneficial effects of the shorter recovery lives of the ACRS
and a decrease in the maximum net capital gain tax rate.
This study provides evidence of the extent to which these
countervailing provisions affect an investor‘s return.

Furthermore, an examination of three specific differentials

17
in aid of newly constructed government-assisted housing
provides evidence as to the wisdom of retaining (or

expanding) those "tax expenditures".

18

CHAPTER I FOOTNOTES

1 U. S. Department of Housing and Urban Deve10pment
(HUD), Housing in the 70' s (Washington: (LS. Government
Printing Office, 1974).;L 1.

2 Housing Act 9; 1949, (LS. Code Annotated, Title 42,
Sec. 1441 (1969).

3 Hearings Before the Committee on Ways and Means--House
of Representatives on the Advisability of Enactment in 1980
of a Tax Cut to be Effective Beginning January 1, 1981, 96th
Cong., 2nd sess., Serial 96-135, pt. 3 at p. 2032 (1980).

4 U.S. Congressional Budget Office, Federal Housing
Policy: Current Programs and Recurring Issues (Washington:
U.S. Government Printing Office, 1978), p. 4.

 

5 U.SL Congress, House of Representatives, Building the
American City--Report Lf the National Commission Ln Urban
Problems to the Congress and to the President Lf the United
States, House Doc. 91- 34, 9lst Cong., lst sess., (1968), P.
406.

 

 

 

 

5 Ibid.

7Report Lf the Staff Lf the Joint Committee Ln
Taxation, 95th Cong., 2nd sess., P. L. 95- -600, (1979), p. 6.

 

8 Net capital gain is the excess of the net long-term
capital gain over the net short-term capital loss.

9 Senate Report, 97th Cong., lst sess., Serial 97-144
(1981)! p. 13.

10 House Report, 97th Cong., lst sess., Serial 97-201
(1981)] p0 2860

11 The Section 8 Program for subsidized housing was
authorized by the Housing and Community Development Act Lf
1974.

CHAPTER II

AN OVERVIEW OF SECTION 8 HOUSING AND THE TAX LAW

AS IT AFFECTS INVESTMENTS IN LOW-INCOME HOUSING

The Department of Housing and Urban Development (HUD)
administers several programs designed to reduce the housing
costs of lower-income persons. The principal federal
housing assistance programs are: (1) low-rent public
housing, (2) Section 235 homeownership assistance, (3)
Section 236 rental assistance, (4) Section 8 existing
housing, (5) Section 8 new construction/substantial
rehabilitation, and (6) rent supplements.

For the 30 years following its authorization in 1937,
the public housing program served as the federal
government‘s primary assistance mechanism. The Section 235,
Section 236, and rent supplement programs were authorized
during the late 1960's and were heavily utilized programs
for several years thereafter. In 1973, activity in the
Section 235 and 236 programs was halted under a national
moratorium imposed by the Nixon Administration.

Housing assistance activity resumed with the passage of
the 1974 Housing and Community Development Act, which

authorized the Section 8 programs. Since that time, Section

19

20
8, low-rent public housing, and a revised Section 235
program have been the most heavily utilized housing
assistance devices. The following discussion is an overview
of the Section 8 housing program administered by HUD and its
relationship to the Michigan State Housing Development

Authority (MSHDA).

HUD Section 8 Program

Section 8 of the Housing and Community Development Act
of 1974 provides for federal assistance to subsidize the
rents of qualified tenants. Under the Section 8 Program,
two principal contracts are executed. First, HUD enters an
"Agreement to Enter into Housing Assistance Payments
Contract" with the owner of the development to be
constructed. This agreement (the "Preliminary HAP
Contract"), subject to certain conditions, commits the
mortgagor and HUD to enter into a Housing Assistance
Payments Contract (the "HAP Contract") upon completion and
acceptance of the development.1 The HAP Contract provides
for the payment of the subsidy by HUD to the owner.

The subsidy contracts provide for the payment of the
Section 8 subsidy for an effective period of not more than
40 years.2 HUD regulations provide that the subsidy will
terminate not later than such time as the mortgage loan is
fully repaid. The Section 8 subsidy is payable only in
respect to eligible tenants (generally defined as persons

whose median adjusted family income does not exceed 70

21
percent of the median family income for the area).3 The
Regulatory Agreement requires that 30 percent of all units
be rented to "very low-income” persons as defined by HUD
regulations.4

It is the obligation of the landlord to ascertain the
eligibility of prospective tenants, but all prospective
tenants are subject to approval by MSHDA. Tenant incomes
are recertified annually (except in the case of the elderly,
who are required to recertify income every two years). A
tenant is not required to leave the project if his income
increases above eligibility limits, but rental assistance
payments for his apartment cease if, and for so long as, his
income equals or exceeds 30 percent of the gross rent for
that apartment.5 The renting of apartment units and the
selection of tenants must be nondiscriminatory and must
comply with a HUD-approved "Affirmative Fair Housing
Marketing Plan".

Section 8 subsidies received by the owner are based
upon the "Contract Rent" applicable to specified dwelling
units. The Contract Rent is initially based on the "fair
market rent" for the dwelling unit, as determined
periodically by HUD, with respect to each locality (and
published in the Federal Register). Contract Rent may be
initially established at up to 120 percent of the fair
market rent. Contract Rent over 100 percent of the fair
market rent requires HUD approval upon a showing of special

circumstances. The amount of the subsidy actually payable

22
to the owner is the Contract Rent less payments made to the
mortgagor by the tenant as determined by HUD. The tenant
payment is limited to 30 percent of family income; for very
large families and in certain other situations, the tenant
payment may be as low as 15 percent of family income.6
Thus, the total rental income from subsidized housing units
payable to or for the account of the mortgagor equals the
Contract Rent, part being paid by the tenants directly to
the owner and the remainder being paid by HUD. The
prOportion of the Contract Rent actually paid by HUD and
that actually paid by tenants varies from month to month
depending upon tenant income.

The maximum amount of money available for subsidy
payments under a HAP Contract equals the initial Contract
Rents for all assisted units in the development. If the
amount actually disbursed under the HAP Contract in a given
year is less than the total available amount, the excess is
set aside by HUD in an account for the particular
development. Such amount is then available to fund future
increases in Contract Rents.

Under the Section 8 Program, as administered for state
housing finance agencies, HUD enters into an Annual
Contributions Contract.("ACC”) with MSHDA. Utilizing funds
received from HUD pursuant to an ACC, MSHDA enters into a
Housing Assistance Payments Contract ("HAP Contract") with a
private owner developing a new multifamily rental project.

The MSHDA agrees to make housing assistance payments to the

23
private owner for. an agreed upon number of units in the
project, which may be less than all of such units. The
monthly payments are equal to the difference between (1) a
negotiated "contract rent" for the covered apartment units
plus any utility a1 lowance, and (2) the rent required to be
paid by the tenants of those units.7

The HAP Contract is executed only after MSHDA has
certified to HUD that the construction of the project is
complete and the local HUD office has verified the
certification. For projects constructed in stages, separate
MSHDA project completion certifications are submitted to HUD
for each stage. When verified by HUD, the HAP Contract is
executed in stages and housing assistance payments with
respect to the completed units are made available. ,All of
the terms of MSHDA's agreements with the project's owner
under Section 8, including the proposed contract rents, are
subject to HUD approval.

Generally, the Section 8 subsidy is payable for a
dwelling unit only when it is occupied by a lower-income
family. However, the law and the regulations provide for
payment of the subsidy under certain limited circumstances
when a dwelling unit is not occupied.

Upon completion of the project, 80 percent of the
Contract Rent for vacant units being held for rent to
eligible tenants is payable during a period not exceeding 60

days. This payment is subject to compliance by the

24

mortgagor with certain conditions relating primarily to a
diligent effort to rent the subsidized unit.

HUD regulations provide that the payment of a subsidy
for a vacant dwelling unit.(whether vacant before or after
initial rent-up) may continue for an additional 12 months.8
The subsidy for a vacant dwelling unit is equal to that
portion of the Contract Rent attributable to debt service on
the permanent financing for the dwelling unit, provided that
(1) the unit is in decent, safe and sanitary condition
during the vacancy period, (2) the owner has taken and
continues to take all feasible actions to fill the vacancy,
(3) the development is not providing the owner with revenues
equal to costs incurred, and (4) the owner submits a
statement with supporting evidence that the development can
achieve financial soundness within a reasonable time.

Provision is made in the regulations for HUD to
determine an automatic annual adjustment factor at least
annually and to publish such factors in the Federal
Register.9 On each anniversary date of the HAP Contract,
Contract Rents are automatically adjusted in accordance with
the factor, subject to a finding that rents in the Project's
marketing area have risen by a comparable amount. In
addition, provision is made in the regulations for special
additional adjustments to reflect increases in actual and
necessary expenses of owning and maintaining the subsidized
units to the extent that such increases are not adequately

compensated by the automatic annual adjustments.

25

Funds for the payment of increased subsidies that may
result from the adjustment, described above, are obtained in
two ways. The law provides for a payment (by HUD) into a
special reserve account for each subsidized development of
the amount by which the Contract Rents exceed the actual
subsidy paid. Initially this is equivalent of the amount of
rent paid by the tenants. The amount of increases in the
subsidy payable by reason of increases in the Contract Rent
are initially drawn from this fund. When the HUD-approved
estimate of required annual contributions exceeds the
maximum HAP commitment then in effect and would cause the
amount in such fund to be less than 40 percent of the
maximum HAP commitment, HUD is required to take additional
steps to obtain funds and bring the amount in the account to
the 40 percent level.

Despite the commitment of HUD to take all necessary
steps to insure that assistance payments are increased on a
timely basis, there can be no assurance that such increases
will be forthcoming. The HAP Contract has an initial term
of five years renewable at the option of the owner for
additional five year periods up to a maximum of 30 years.
Even during the 30-year commitment period, however, the
yearly contributions are subject to annual appropriation by
Congress.

The regulations provide that in the event of
foreclosure, or assignment or sale to MSHDA in lieu of

foreclosure, or in the event of an assignment or sale agreed

26

to by MSHDA and approved by HUD, subsidy payments will
continue in accordance with the HAP Contract.

The Preliminary HAP Contract and the HAP Contract each
contain numerous agreements on the part of the owner
including maintenance of the development as decent, safe and
sanitary housing and compliance with a number of
requirements typical of federal contracts (such as those
relating to nondiscrimination, equal employment opportunity,
relocation, pollution control and labor standards).
Noncompliance by either HUD or the mortgagor, or both, might

endanger the payment of the federal subsidy.

Michigan State Housing Development Authority (MSHDA)

The MSHDA was established by the Housing Development
Authority Act of 1966 (the "MSHDA Act"). It is an
independent state agency governed by a seven-member board.

The MSHDA provides nonrecourse construction and
permanent loans at rates lower than conventional market
rates for multiple-unit housing projects designed to be
available at low- and moderate-rentals.

The MSHDA was created to assist in providing an
adequate supply of housing for persons and families of low
and moderate means. The enabling legislation authorized
MSHDA to finance housing by purchasing mortgages and by
making or participating in the making of construction and

permanent mortgage loans to eligible sponsors, as well as

27

directly to persons and families of low- or moderate-income.
In each case, MSHDA must determine that financing is not
otherwise available from private lenders upon reasonably
equivalent terms and conditions. All rental determinations
and tenant selection plans are subject to MSHDA approval.

During the period of indebtedness to MSHDA, the
mortgagor must conduct itself as a limited-profit entity as
that term is defined in the Michigan Statutes. Any and al 1
distributions, including any available distributions upon
dissolution, are expressly subject to Michigan statutes.
The annual cash return on equity to the investors may not
exceed a MSHDA-determined percentage.10 All distributions
in any one fiscal year are limited to six percent of the
equity investment. Although the right to make a six percent
distribution is cumulative, MSHDA has no obligation to
approve any increase in rentals for the purpose of providing
a surplus for distribution of accumulated deficiencies from
prior years. In any event, no distribution can be made (1)
without the approval of MSHDA, (2) at any time other than
after the end of an annual fiscal period, (3) prior to the
final closing, or (4) except in compliance with the
provisions of the Regulatory Agreements, the rules and
regulations of MSHDA and the laws of the State of Michigan.

The mortgage and the regulations of MSHDA impose
certain restrictions on the sale of a development.11
Accordingly, the investors are not able to dispose of the

development without MSHDA's consent while the loan is

28
outstanding. Also, the loan may not be refinanced without
MSHDAIs consent for 20 years after commencement of
amortization. It may be refinanced thereafter only upon
payment of a prepayment penalty in an amount calculated as
provided in the mortgage note.

The activities of the project are regulated by MSHDA,
which has the power, among other things, to (I) examine all
books and records, (2) supervise the Operation and
maintenance of the property, (3) fix rents, (4) control
tenant selection, and (5) determine that the mortgage loan
is in jeopardy of not being repaid, that the develOpment is
in jeOpardy of not being constructed or that the investors
are otherwise not carrying out the intent and purposes of
the statute under which MSHDA was established.12 In any
such event, MSHDA may appoint a manager who has full control
over any and all Operations.

The agreement between MSHDA and the investors with
respect to such restrictions, regulation, and control is set
forth in a MSHDA Regulatory Agreement. MSHDA reviews each
application for financing to determine, prior to making a
commitment with respect to a project, whether the project is
sound physically and economically and will generate
sufficient income from rents to pay all operating costs plus
principal and interest.

Capital for MSHDA loans is obtained from the sale of
tax-exempt anticipation notes and bonds. MSHDA loans are

general 1y equal to, but in no event more than, 90 percent of

29
the project replacement cost as computed by MSHDA for the
limited-profit mortgagor. The permanent loan has a term of
30 years. The policy of MSHDA is to set the interest costs
for construction loans at a premium over the prevailing rate
at which MSHDA must sel 1 its notes and to set the maximum
interest costs for permanent loans at the prevailing bond
market plus an additional 1 1/2 percent per annum.

The MSHDA reserves the full power to refinance any or
a1 1 of its borrowings, the proceeds of which are used to
provide construction and/or permanent mortgage loans. In
the event of any such refinancing that results in an
adjustment to the interest costs, such adjustments may be
passed along to the entities to which MSHDA has provided
construction or permanent financing. The MSHDA mortgages
include provisions that mortgage payments may be increased
to cover administrative and bond payment expenses. The
mortgage loan made by MSHDA to the mortgagor is a non-
recourse loan.

Pursuant to Section 15a of the State Housing
Development Authority Act of 1966 (MCLA 125.1415a), Section
8 housing is exempted from real estate taxation but is
required to make payments in lieu of real estate taxes to
reimburse the municipality for services provided. The
amount of reimbursement is limited to the greater of the tax
in effect on the property prior to the date construction

began or 10 percent of the annual shelter rents (defined as

30

the rents paid by tenants of the project minus portions of

rental payments attributable to utility costs).

A Historical Review of Tax Laws
Affecting Low-income Housing
The development of the federal tax law involving low-
income housing investments is presented below; The purpose
is to provide a perspective for understanding the tax

changes that form the basis of this study.

Investment Vehic l e

To provide "tax shelter," an investment must be able to
pass through to the investors any losses, capital losses,
capital gains, or credits. Partnerships, and more
specifically limited partnerships, provide this conduit
feature which, with limited exceptions, is not available in
the corporate form of organization. Therefore, the
availability of tax benefits to an investor is usually
dependent upon classification as a partnership rather than
as an association taxable as a corporation.

The classification of an entity under state law does
not control for federal income tax purposes. Whether or not
an entity will be considered an association (and thereby
taxed as a corporation) for federal income tax purposes
depends upon the number of corporate attributes it
possesses. Reg. Sec. 30l.7701-2(a) lists six attributes of

a "pure“ corporation:

31
1. associates
2. an objective to conduct a business and divide the
gains therefrom

3. continuity of life

4. centralized management

5. limited liability

6. free transferability of interests

The tax regulations provide that an unincorporated
organization shall not be classified as an association
unless it possesses more corporate than noncorporate
attributes. In making this determination, the attributes
common to both corporations and partnerships (iJe., one and
two above) are disregarded. Therefore, a partnership must
possess three or more of the last four attributes before it
will be classified as an association for federal income tax

purposes.

General Principles pf Partnership Taxation

 

 

 

A partnership files an annual income tax return but is
not subject, as an entity, to federal income taxes. Each
partner is required to report an allocable share of the
partnership income, gain, loss, credit and items of tax
preference. Each partner is subject to tax on a
distributive share of the partnershipfls annual taxable
income, regardless of whether any distribution is actually
made during the year. Consequently, a partner's share of

the taxable income of the partnership, and the tax liability

32
with respect thereto, may exceed the cash and the value of
other property actually distributed in a given taxable year.

Present law permits each partner to deduct his share of
the partnership‘s losses against income from other sources
to the extent of the tax basis Of his interest in the
partnership determined as of the close of each taxable year.
Losses that exceed a partner's tax basis may be carried over
indefinitely and deducted in any year to the extent such
basis exceeds zero.

In any low-income housing syndication it is anticipated
that the tax losses from ownership and Operation will
decline over time and eventually will produce taxable income
in excess of cash flow from normal operations. This arises
because the annual depreciation deductions, under
accelerated depreciation methods, decline from year to year.
In addition, under a substantially level payment mortgage
(such as a MSHDA Mortgage Loan), the portion of each payment
that represents nondeductible amortization of principal
increases from year to year and the portion representing
deductible interest decreases.

If the cash distributed by the partnership for any year
exceeds its taxable income for the year, the excess
constitutes a return of capital. This return first reduces
the tax basis of the recipient’s interest in the
partnership. Any amounts in excess of such tax basis result
in a recognition of gain by such partner in the amount of

such excess. To the extent that such a distribution is

33
attributable to "substantially appreciated" inventory or
"unrealized receivables" (including depreciation subject to

recapture) it will be taxed at ordinary income rates.

Calculation of a Partner's Adjusted Basis

 

A partner may offset income earned from other sources
by his distributive share of partnership losses. A partner
is entitled to deduct his distributive share of the
partnershipfls net loss to the extent of the adjusted basis
in his interest. Under current law, a partner's adjusted
basis in his interest is equal to the amount of cash
contributed increased by (1) his pro rata share (in the same
proportion as such partner shares partnership profits) of
nonrecourse indebtedness to which the partnership property
is subject, and (2) his pro rata share of items of
partnership income and gain, and reduced, but not below
zero, by (a) his pro rata share of items of partnership loss
and deduction and (b) any cash distributions received by
such partner from the partnership.

In calculating a partner‘s adjusted basis in his
interest, any reduction in the amount of the partnership"s
nonrecourse indebtedness (including a reduction due to
monthly amortization of the mortgage loan) is treated as a
cash distribution. A reduction in a partner‘s allocable
share of partnership nonrecourse debt reduces the adjusted
basis of such partner's interest.

Commencing in taxable years beginning after 1978,

Section 465 Of the Code limits the amount of loss that a

34

taxpayer may claim on investments to the amount that the
taxpayer has "at risk". These limitations do not apply,
however, to any partnership the principal activity of which

is holding real property (other than mineral property);t3

Depreciation and Depreciation Recapture

 

Current federal income tax law permits a taxpayer to
claim recovery deductions based on the entire cost of
depreciable improvements, even though such improvements are
financed with borrowed money.

Prior to the ERTA of 1981, buildings were depreciated
under either the composite method or the component method.
Under the composite method, a group Of assets are placed
into a single account and depreciated at a single rate. For
example, a building would be depreciated by applying a
single rate to the composite account. The rate was
essentially a weighted average, equal to the sum of the
annual depreciation deductions allowable for each component,
divided by the total cost of the components. The taxpayer
was allowed to calculate the composite rate in this manner
if he was able to establish the useful life and the cost of
each component.

Alternatively, the taxpayer could use the guideline
composite life provided by the Class Life Asset Depreciation

Range (CLADR) system to determine the composite rate. There

are no CLADR classes for real prOperty; however, a taxpayer

electing CLADR may determine the useful life of real

35
property by reference to Rev. Proc. 62-21 (1962-2 CB 418).
The guideline life, under Rev. Proc. 62-21, for an apartment
building is 40 years. Utilizing this life would yield a 200
percent declining balance (200 DB) rate Of five percent.

In the case of component depreciation, each structural
component is segregated and depreciated separately. The
effective useful life produced under this method is
generally shorter than the guideline composite life. Hence,
this method generally produced larger recovery deductions in
the early years of ownership.

Under the ACRS enacted by the ERTA Of 1981, real
property is assigned a 15-year recovery period, but
taxpayers may elect straight-line cost recovery over a 15,
35, or 45 year extended period. Composite depreciation is
required. For real property other than low-income housing,
the property can be depreciated using a maximum 175 percent
declining balance (175 DB) method, changing to the straight-
line method to maximize acceleration. Low-income housing
can be depreciated under a maximum 200 DB method changing to
straight-line.

While accelerated depreciation tends to provide
investors with a tax deferral in the early years of shelter
Operations, it is not without disadvantages. Excess
depreciation on real property is a tax preference item with
potential effects on both the minimum tax and, prior to
1982, on the maximum tax. Additionally, when the property

is sold, the depreciation recapture provisions of Sec. 1250

36
may reclassify part or all of any resulting gain as ordinary
income.

The Code provides that, in the event Of the sale or
other disposition of depreciable real property, all
depreciation claimed with respect to the property is
"recaptured" (iJL, is subject to tax at ordinary income
rates) if the sale or disposition occurs before the property
has been held for more than a year. If the property has
been held for more than a year at the time of such sale or
disposition, then it is usually necessary to segregate the
excess depreciation claimed into three components: post-
1975 excess depreciation, post-1969 to pre-1976 excess
depreciation, and pre-1970 excess depreciation. When a
portion of the gain is subject to recapture under more than
one set of rules, it is necessary to recapture the
depreciation attributable to the most recent component
first. Thus, excess depreciation attributable to the post-
1975 component is recaptured before any recapture of the
excess depreciation claimed in the earlier components. If
the recognized gain exceeds the aggregate excess
depreciation from each prior step(s), the procedure is
repeated until all of the recapturable income from each
component is determined. Figure 1 on the next page

summarizes the provisions of Sec. 1250.

37

Excess Depreciation Residential Government-
(Cost Recovery) Rental Real assisted
Components Attribu- Property Housing

table to the Period: (generally)l
1976 through the 100 percent 200 month rule2
date of disposal recapture

1970 through 19753 200 month rule 120 month rule2
1964 through 19693 120 month rule 120 month rule

 

 

 

 

1. See IRC Secs. 1250(a)(1)(B) and 1250(a)(2)(B).

2. The applicable percentage under the 200 month rule
is 100% less 1% for every month the property is held
in excess of 100 months. The applicable percentage
under the 120 month rule is 100% less 1% for every
month the property is held in excess of 20 months.

3. Note that although the recapture rules have been changed
twice since 1963, any excess depreciation attributable
to years prior to 1976 is still recaptured under these
rules. The holding period is always computed from the
acquisition date to the disposal date.

Figure 1. Applicable Recapture Percentages For Section 1250
Property.

38

Whether or not the property has been held for more than
a year, the amount of depreciation subject to recapture, as
determined in accordance with the above rules, can never
exceed (1) in the case Of a sale, exchange or involuntary
conversion, the excess of the amount realized over the
adjusted basis of the property; or (2) in the case Of any
other disposition, the excess of the fair market value of
the property over its adjusted basis.14

These depreciation recapture rules apply to the sale or
other disposition Of a partnership interest. However, the
amount of recapture attributable to such sale or disposition

is limited to the partner‘s pro rata share of the project's

excess depreciation with regard to real property.

Gains 9g Sales of Limited Partnership Interests

 

In general, the sale of a limited partnership interest
by a holder who is not a "dealer" with respect to such
interest is treated as a sale of a capital asset. However,
gain on such a sale would be subject to ordinary income tax
rates to the extent that the partnership holds inventory
items that have "substantially appreciated" in value or
"unrealized receivables" (including depreciation recapture)
as these terms are defined in Code Sec. 751. The amount of
gain realized on the sale of any interest will, in general,
be the excess of the sale price plus the limited partner's

share of liabilities as to which no partner has any personal

39

liability (such as the MSHDA Mortage Loan) over the adjusted
basis Of the limited partner's interest.

In determining the amount realized on the disposition
of the project, the amount of the outstanding mortgage loan
is treated as money received by the partnership-15 This is
true even when the fair market value Of the property in
question is less than the outstanding balance of the
mortgage indebtedness secured by the property. For example,
if, at the time of a mortgage foreclosure, the tax basis of
the project was $1,000,000, the principal balance of the
mortgage loan was $1,500,000 and the project was sold for
$1.00 on foreclosure, the amount of taxable income
recognized on such sale would be at least $500,001 even if
the project had a fair market value Of less than $1,500,000.
However, no cash would be available for distribution, so
that the limited partners would have substantial gain with
no current distribution of cash to pay any tax due. If,
instead, the project were sold for a price above the then
outstanding balance of the mortgage loan, the adequacy of
the cash to pay taxes due would depend upon the specific
facts. The amount of gain recognized on a foreclosure or
sale is treated as a Section 1231 gain except that the
portion Of the gain representing "depreciation recapture"
attributable to the project is treated as ordinary income in

accordance with the rules set forth above.

40

Construction Period Interest and Taxes

 

The most significant provision of the TRA of 1976
restricting the availability Of early year (front-end)
deductions in a tax shelter was Code Section 189. It
provides that amounts paid or accrued by a taxpayer that
constitute "construction period interest and taxes" on real
property are not deductible in their entirety for federal
income tax purposes in the year paid or accrued. They are
required to be capitalized and amortized over subsequent
years beginning with the year following the year paid or
accrued or, if later, the year in which the property is
placed in service.

Separate transitional rules were provided for non-
residential real estate, residential real estate, and low-
income housing. In the case Of low-income housing, the
limitations set forth were to apply to construction period
interest and taxes paid or accrued in taxable years
beginning after 1981. As previously noted, the ERTA Of 1981
permanently exempts low-income housing from the requirement

to capitalize construction period interest and taxes.

The Minimum and Maximum Tax

 

Restricting depreciation and the current deduction of
construction period interest and taxes represents a direct
approach to reducing the deferral and conversion aspects of

a tax shelter. The adoption of the minimum and maximum tax

41

provisions in the Tax Reform Act (TRA) of 1969 represented a
unique approach toward tax equity.

The minimum tax was conceived to insure that taxpayers
with large economic income, but little or no taxable income
due to certain tax incentives, paid some income tax. Prior
to the TRA Of 1969, no limit was placed on the amount Of
income that a taxpayer could exclude from tax as a result of
the various incentive tax provisions. Many taxpayers with
high incomes, who could benefit from the these incentives,
paid lower effective rates Of income tax than many taxpayers
of modest income. In some cases, taxpayers with large
economic incomes paid no tax at all.

The maximum tax provisions were adopted with the
justification that high rates of tax on earned income tended
to create distortions in our tax system. It was thought
that one way to reduce the use of tax avoidance devices was
to reduce the high tax rates on earned income, but only
where these devices generally were not utilized.

The TRA of 1969 imposed an “add-on" minimum tax equal
to 10 percent Of the sum of an individual's tax preferences,
reduced by the taxpayer's regular income tax and a $30,000
exemption. Among the tax preference items subject to this
tax were two items relevant to investors in low-income
housing. They were the excluded half of the taxpayer‘s
long-term capital gain and that portion of the depreciation

on real property in excess of straight-line.

42

Because the minimum tax provided a rather generous
exemption ($30,000 plus the individual's regular income tax
liability), few taxpayers ever incurred a minimum tax
liability. This provision was amended by the TRA of 1976
which reduced the exemption to the greater Of $10,000 or
one-half of the individual's regular income tax liability.
Additionally, a carryover Of the unused portion of the
taxpayer's regular income taxes as an Offset against tax
preference items Of subsequent years was eliminated and the
tax rate increased from 10 to 15 percent. This substantial
tightening of the minimum tax rules applied to preferences
arising from pre-TRA of 1976 investments.

Because the more restrictive rules of the TRA of 1976
caused a hardship for taxpayers with large nonrecurring
capital gains, the RA of 1978 restructured the minimum tax.
After October 31, 1978, the excluded portion of any long-
term capital gain is no longer a tax preference item for
purposes of the add-on minimum tax.

Under the RA Of 1978, a new minimum tax (known as the
"alternative minimum tax") was created. The starting point
in computing this tax is gross income. When gross income is
reduced byiall allowable deductions and increased by the sum
of the tax preferences for adjusted itemized deductions and
for the capital gains deduction (increased to 60 percent by
the RA Of 1978), it yields an amount known as "alternative
minimum taxable incomeJ' The tax rate applied to this

income was: zero on the first $20,000; 10 percent on the

43

next $40,000; 20 percent on the next $40,000; and 25 percent
on the excess over $100,000. The taxpayer's alternative
minimum tax is the excess of the tax determined on the
alternative minimum taxable income over the taxpayer's
regular income tax liability (if any).

Two amendments to the minimum tax provisions relevant
to real estate investments were made by the ERTA of 1981.
First, to conform the alternative minimum tax to the maximum
tax rate on long-term capital gains of 20 percent, the
maximum rate was reduced to 20 percent of alternative
minimum taxable income in excess of $60,000. Second, the
add-on minimum tax preference for accelerated cost recovery
on 15-year real property was modified to the excess of the
cost recovery deduction over 15 year straight-line cost
recovery.

The TRA of 1969 provided for a maximum tax rate of 50
percent on earned income to reduce the incentive to shelter
this form of income. The Act also provided that in certain
circumstances the income eligible for the maximum 50 percent
rate would be reduced. To the extent an individual's tax
preferences exceeded $30,000, income eligible for the 50
percent maximum was reduced on a dollar for dollar basis.

The TRA of 1976, in a further effort to reduce the
incentives for tax shelters, eliminated the $30,000
preference exemption. After 1976, all tax preference items
reduce the individual's income (dollar for dollar) eligible

for the 50 percent maximum tax. However, the Act also

44

expanded the income eligible for the 50 percent maximum to
include personal service income. This expanded definition
includes pension, annuity, and deferred compensation income.
The RA of 1978, in line with the adoption Of the
alternative minimum tax, eliminated the long-term capital
gain deduction as an offset against income eligible for the
50 percent maximum effective for sales after October 1978.
The ERTA of 1981 reduced the maximum marginal tax rate
on all income, passive or earned, to 50 percent beginning in
1982. Thus the maximum tax was no longer required and was

repealed for tax years beginning after 1981.

Certain State Tax Aspects

 

The partnerships in this study are organized under the
laws of the State Of Michigan. Michigan revised its
taxation Of business by levying, effective January 1, 1976,
a "single business tax" on the privilege of doing business
within the State. The single business tax applies to every
individual, corporation, partnership, estate, or trust with
"business activity" allocated or apportioned to Michigan.
Business activity, for purposes of the single business tax,
includes the rental Of real property.

The single business tax replaces the Michigan income
tax with respect to corporations. Individuals, estates, and
trusts remain subject to the Michigan income tax.

The single business tax imposed on the partnership for

any taxable year will, under present Michigan law, be 2.35

45
percent of the lesser of either:
1. 50 percent of the adjusted gross receipts of the
Partnership, or

2. the "adjusted tax base" of the Partnership.

The adjusted tax base of the partnership for any
taxable year will ordinarily be the federal taxable income
(or loss) Of the partnership for the year modified by:

1. adding certain expenses, such as compensation

paid, interest paid, and depreciation on real
and personal property, deducted for federal
income tax purposes for the year: and

2. subtracting (a) interest received, and (b) the

cost of depreciable real and personal property
paid for by the Partnership during the year
(the "Capital Acquisition Deduction"), and (c)
an exemption for small business.

If this calculation produces a negative adjusted tax
base, the "loss" is carried forward as an Offset to the
adjusted tax base for the years following the loss year or
until the loss is utilized, whichever occurs first. Because
of this carryover provision, none Of the partnerhips in this
study will incur a single business tax in their first 16

years.

Risk
Risk is an important factor in evaluating the potential

return from an investment. Much of the current research in

46

accounting utilizes some measure of risk. Several attempts
to quantify the risk Of a real estate investment have been
conducted using highly simplified data. No attempt has yet
been made to quantify risk in a real estate investment
utilizing a limited partnership as an investment vehicle.
The following discussion is intended to acquaint the reader
with some potential problems in quantifying the risk of a

government-assisted housing investment.

General Risks 9: Real Estate Ownership

 

 

Investments in real estate ventures are subject to the
risk Of adverse changes in general economic and local
conditions, such as an over-supply of dwelling units in the
area; lack of attractiveness of the property to tenants:
adverse changes in neighborhood values; zoning laws, rent
controls, other laws and regulations regarding real property
tax rates; and the ability of the enterprise to provide for
adequate maintenance of its property. Also, certain
expenditures associated with equity investments in real
estate (principally mortgage payments, real estate taxes and
maintenance costs) are not normally decreased by events

adversely affecting income.

Construction Completion

 

The construction Of the project entails risks such as
strikes, energy shortages, shortages Of material and labor
for construction, inflation, adverse weather and other

contingencies that can cause costs to exceed estimates.

47

Completion of the project may also be delayed or prevented
by environmental, zoning, title or other matters that may
arise during construction. .A considerable delay in
construction might adversely affect the ability to meet the
terms of the construction loan and could result in
foreclosure. In addition, a delay in completion would cause
a delay in the commencement of the payment to the
partnership of Housing Assistance Payments from MSHDA (as

agent for HUD).

Financing Risks

 

Under the Building Loan Agreement that provides the
terms under which MSHDA will supply the construction
financing, failure to complete the construction of the
project could constitute an event of default that could lead
to additional financing fees or foreclosure. There is no
assurance that MSHDA would grant a mortgage increase to
cover additional construction or financing costs. If MSHDA
fails to provide the full amount of the permanent loan,
alternative financing, if available, most probably would be
less favorable.

The projects examined in this study are subject to the
MSHDA Regulatory Agreement. The Regulatory Agreement limits
the landlord's ability to raise rents without MSHDA
approval, limits the ability to refinance the permanent loan
without first paying a prepayment penalty, and requires

certain escrows that may only be applied to operating

48
deficits, capital improvements, amenities and similar
expenditures. The limitations of the Regulatory Agreement
and MSHDA may, in some circumstances, jeopardize the

viability of the project.

Tax Risks

 

Partnership Status-~The IRS is not bound to follow any
Opinion of counsel regarding the interpretation of existing
tax laws. There can be no assurance that the IRS wil 1 not
assert that the partnership should be treated as an
association taxable as a corporation. If the partnership
were treated as an association, al 1 or some portion of the
distributions made to the partners may be taxable as
dividend income. Additionally, the partners would not be
able to utilize their share of the net losses of the
partnership on their federal income tax returns.

Utilization of Benefits-~The desirability of an
investment in these partnerships depends primarily upon the
investor limited partner's ability to use the projected
benefits that flow from the present federal income tax
treatment of investments in a partnership. iNormally, an
anticipated benefit is the ability to apply tax losses of
the project against taxable income from other sources for an
extended period of time. Failure to maintain substantial
taxable income from other sources will adversely affect the
investor's return.

Tax Reform--The IRS, could, at any time, change its

present position on certain types of tax treatment.

49

Furthermore, Congress has been considering certain tax
reform measures. Changes in the federal income tax laws,
including the promulgation of rules and regulations and the
enactment of additional legislation, may eliminate or reduce
the anticipated tax benefits.

Basis-—The note evidencing the mortgage loan provides
that no partner is personally liable for the repayment
thereof. The partnership relies on the nonrecourse aspect
of the mortgage loan to provide an increased basis to the
investor limited partners to allow them to deduct
partnership losses. If the IRS should determine that one of
the partners is in fact personally liable, the other
partners could be substantially limited in the amount of

partnership losses they may recognize.

MSHDA and HUD Restrictions and Regulations

As a governmentally-assisted Section 8 Project, the
extent of supervision and regulation of its management and
Operations by MSHDA is significant. This includes a
requirement to obtain approval for actions that otherwise
would not be subject to supervision and control by a third
party. The consequence of such governmental involvement may
cause delays in obtaining evictions, alterations, and
repairs and rent adjustments. In addition, MSHDA may adopt
rules and regulations in the future that further restrict

the management and operation of the project.

50

Housing assistance payments are only available to units
leased to eligible tenants. If the project is not fully
rented to eligible tenants, the remaining units must be
operated as a conventional project under the same rent
restrictions and rules and regulations of MSHDA but without
the benefit of housing assistance payments.

The documents relating to the construction and
financing place various obligations on the partnership and
the construction company, including, among other things,
non-discrimination covenants with respect to the tenants of
the project, and an obligation to lease at least 30 percent
of the units to "very low-income families", an Obligation to
complete construction of the project on time, and the
obligation to employ minority subcontractors to the extent
possible and to comply with equal employment obligations and
other requirements under federal and Michigan Law. The
mortgage, Regulatory Agreement, and rules of MSHDA impose

further restrictions on sale or refinancing.

Occupancy

 

If occupancy levels necessary to maintain the breakeven
point are not reached, the partnership may request increased
apartment rents which are obtainable only with the consent
of MSHDA. However, there can be no assurance that such
consent will be obtained. For reasons over which the owner

has no control, MSHDA may be unable or unwilling to

51

authorize additional rental adjustments or may delay in
doing so.

In addition, the local rental market, together with
applicable regulations as to eligible tenants, may limit the
extent to which rents may be raised without lowering the
occupancy rate. Even if a rent increase is approved, it is
probable that delay will occur in its implementation.
Additionally, if the mortgagor is unable to meet its
Operating expense and debt service payments, this could

result in mortgage foreclosure.

Limited Transferability

If a limited partner wishes to transfer his unit(s), he
wil l in al 1 likelihood find no market for it. This may be
due to the diminishment of the tax advantage of accelerated
depreciation which, while high in earlier years, will
decline over the life of the project. Secondly, although
the permanent loan is a level payment Obligation, amounts of
deductible interest decrease and the amounts of non-
deductible mortgage amortization increase with each monthly
payment. Prospective investors may not wish to purchase a
unit without the advantages of the earlier depreciation
deductions which were in excess of the amortization of the

mortgage principal.

8
9

10

52

CHAPTER II FOOTNOTES

24 C. F. R. 883.410 (1983 ed.)
24 C. F. R. 883.101(b) (1983 ed.)
24 C. F. R. 883.302 (1983 ed.)
24 C. F. R. 883.704(C) (1983 ed.)
24 C. F. R. 883.704 (1983 ed.)
24 C. F. R. 883.304 (1983 ed.)
24 C. F. R. 883.307 (1983 ed.)
24 C. F. R. 883.712 (1983 ed.)
24 C. F. R. 883.710 (1983 ed.)

Michigan State Housing Development Authority,

Regulatory Agreement- Limited Dividend Rental Housing
Development (Form No. PLCD 230-8) p. 2.

11

12
13
14
15

Ibid, p. 8.

Ibid, p. 5.

IRC Sec. 465(c)(3)(D).
IRC Sec. 1250(a)(1)(A).

IRC Sec. 752.

CHAPTER III

A REVIEW OF RELATED STUDIES

This chapter reviews and evaluates other major studies
involving the tax aspects of real estate investments. The
objectives, methodology, and a summary of the results

distinguish the previous studies from this one.

Limitations of Previous Studies
Many of the previous works contain shortcomings and

limitations which may be divided into two groups.

Group One

 

Several early studies utilized only one marginal tax
rate. Instead of recognizing that an investor's loss could
straddle several marginal tax rates, the entire loss is
assumed to produce tax savings at one constant rate (ixn,
50, 60, or 70 percent). ‘Furthermore, all of the early
studies ignored the effects of the minimum and maximum tax
provisions on investments in real estate. Thus the results
do not incorporate the adverse effects Of the minimum tax on
returns or the potential loss of benefits from the maximum

tax.

53

54

Group Two

 

The more recent studies, which aim at correcting the
group one shortcomings, base their conclusions on only one
or two sets of simulated real estate data. The one study
that examined syndicated investments specifically ignored

the special tax provisions in aid of low-income housing.

Review of Previous Studies

The McKee Study

The first major study to examine a real estate
investment by computer was conducted by McKee. Although the
stated purpose of the study was to identify the relative
impact of tax shelter and financial leverage on real estate
investment returns, the author goes on to conclude that a
"real estate tax shelter is an inefficient and inequitable
form of subsidy"3~

The study takes a simplified view; considering tax
shelter as arising from only two components--deferral and
conversion. The author suggests that these benefits are
solely the result Of tax depreciation not accurately
reflecting economic depreciation. He further states that
the allowable methods and the useful lives allowed by tax
law in combination with the inclusion of borrowed funds
(leverage) in the depreciable base allow an "unwarranted
depreciation".

A computer model for direct investment in purchased

rental property was developed to analyze the impact of

55
various factors on profitability. The specific objectives
Of the study were to examine: (l) the impact of changing
tax rates and mortgage interest rates on rates of return,
(2) the effects of leverage on conversion and deferral, and
(3) the effects of accelerated depreciation and the
recapture provisions on tax shelter. The results can be
summarized as follows:

1. As the tax rate increases, the value of the tax
shelter and tax shelter leverage increases.

This result occurs because more tax is deferred
until sale and because the rate conversion
(ordinary income into potential net capital
gain) is greater.

2. As the rate of return increases the value of
the conversion component declines, while the
value of the deferral component rises.

3. Accelerated depreciation retains substantial
value after the deduction falls below that
(allowable under the straight-line method. The
impact of recapture on the return in a tax
shelter is relatively small and especially so
when it is subject to a phase-out (e.g., 200
month rule).

4. The impact of financial leverage on the return
is reduced by a percentage equal to the

investor's tax rate.

56

The Hemmer Article

Probably the most elaborate early computer analysis of
real estate investments was presented in an article by
Hemmer.2 It described the interrelationships of variables
which developers, lenders, and investors required to assess
real estate investments. Financing and operating
characteristics were modeled to allow for evaluation under
various assumptions. Another unique characteristic was the
ability to calculate the internal rate of return on an
investment for both the developer and the lender in addition
to the investor.

It permitted an estimate of probable outcomes based on
a combination of more than 100 construction, leasing,
financing, and Operating practices. However, the model did
not incorporate the minimum or maximum tax provisions. The
tax savings produced by the losses from the investment were
determined by applying a single tax rate to taxable income.
A net capital gains tax rate of 30 percent was utilized in
every application.

Although the article was primarily a demonstration of
the usefulness of computer modeling in real estate
investment analysis, it drew several other conclusions:

1. It was not possible to adequately describe the
interrelationships among all of the variables
without a sophisticated valuation model.

2. A computer model can be used to determine the

most favorable combination of various operating

57

and financial parameters.
3. The correctness of decisions can be disproved

or verified with the model.

The Cleveland Dissertation

Cleveland (1973) authored a dissertation which, in
part, examined the tax provisions applicable to low-income
housing.3 However, his major objective was to determine the
effect of the TRA of 1969 on the perceptions of investors in
all forms of real estate. A questionnaire survey and
personal interviews with tax experts, trade association
officers, developers, Treasury officials, and mortgage
bankers were the primary means of collecting data.
Furthermore, a valuation model was constructed to measure
the impact of the depreciation, recapture, and low-income
housing provisions of the TRA of 1969.

The study made no attempt to simulate an investment
over time. The only major difference between the three
types of projects examined was the method Of depreciation
utilized. The valuation model omitted several provisions of
the 1969 Act relevant to real estate, such as those creating
the minimum and the maximum tax.

Failure to simulate over time, to adequately model
financial and operating characteristics, and to incorporate
several significant tax aspects provides only a rough
estimate of the effects of the TRA of 1969. As a result,

some of the conclusions (numbers two and three below)

58
regarding low-income housing appear suspect. The major low-
income housing conclusions include:

1. The rate Of return on a project declines as the
mortgage interest rate rises.

2. Reducing the depreciable life from 40 to 35
years causes the maximum return to be shifted
from a 30 percent taxpayer to a 70 percent
taxpayer.

3. Using a 40 percent operating ratio and a 35
year life, a 70 percent taxpayer did not obtain
a positive return until the property was held

for 8 years.

The Wyndelts Dissertation

Wyndelts (1974) studied the impact of the TRA of 1969
on the internal rate of return of investments in new
residential real estate.4 The objective was to determine if
Congressional intent (as reflected in housing legislation)
to stimulate new housing was effectively being communicated
to real estate investors by national firms' real estate
investment models.

Wyndelts developed a computer model that incorporated
the relevant tax provisions before and after the TRA of 1969
in much greater detail than previous studies. This model
reflected the tax rate schedules, the maximum tax, and the
alternative net capital gains tax rate, but omitted the

minimum tax.

59

To test the proposition that investment incentives
contained in the TRA of 1969 were distinguishable by
valuation models used in practice, three tests were
developed. For each test, the internal rate of return was
computed using a national firwfls real estate model and his
own model. Only the Wyndeltds model incorporated the tax
rate schedules, the alternative net capital gains tax, and
the maximum tax provisions. Two tests were develOped to
determine if a significant difference in the internal rates
of return, produced by the models, resulted from: (1) the
use of the tax rate schedule instead of the taxpayer's
marginal tax rate in computing tax savings from the
investment, or (2) the use of the most beneficial method of
computing tax on a sale of the property instead of the
taxpayer's marginal tax rate. A third test was designed to
compare the model's sensitivity to changes in depreciation
rules contained in the TRA of 1969. The internal rates of
return for each model for new and used real estate
(differing by method of depreciation) were compared.

A conclusion was drawn that valuation models used by
real estate firms did not produce accurate measures of real
estate investment return. Only the impact of changes in
depreciation methods was reasonably estimated by the models

in use.

60

The CBO Study

In May 1977, the CBO published Real Estate Tax Shelter

 

Subsidies and Direct Subsidy Alternatives.5 This study
evaluated several alternative subsidies for low- and
moderate-income rental housing. It reached the following
conclusion on income tax provisions related to government-

assisted housing:

Real estate tax-shelter subsidies rest on a
complex and delicate structure of administrative
rulings and tax laws. Seemingly small changes can
undermine or even collapse the entire
structure....While this vulnerability to small
changes is true of real estate tax shelters
generally, it is an especially serious problem for
low- and moderate-income rental housing....Removal
or reduction of any one of the subsidies could
make a project uneconomical.

..uLess than two-thirds of the estimated
$1.3 billion a year the government loses in tax
revenue from real estate tax shelters is used to
subsidize construction of rental housing. The
remainder subsidizes the construction of office
buildings, shopping centers, and other commercial
buildings. And Of the total subsidy, only about
11 percent is used to assist low- and moderate-
income rental housing construction.6

The study also concludes that the primary reason for
the small share of tax subsidy benefitting low-income
housing is that:

....until the Tax Reform Act of 1976, low-
income rental housing did not receive
substantially more favorable tax shelter benefits
than other forms of rental housing. The major
deductions--those for construction period interest
and taxes and accelerated depreciation--were the
same for both low-income and upper-income rental
housing. Low-income rental housing did receive
some additional benefits in the Tax Reform Act of
1969 from more rapid phase out of the recapture
requirement"., but these are much less important
overall than the major deductions. At least until

61

the effects of the Tax Reform Act of 1976 begin to

be reflected in the totals, therefore, the low-

income share of the total rental housing tax

shelter subsidy will not be substantially larger

than the low-income share of total rental housing

starts.

The Stern Dissertation

Stern (1979) studied the combined impact of the TRA of
1976 and the RA of 1978 along with two proposed (1978) tax
law changes on the internal rates of return and optimal
holding periods of a direct investment in an apartment
building (residential) and a motel (commercial).8 Two
generalized deterministic computer simulation models
addressed a total of 864 sets of assumptions pertaining to
the character and size of an investor's pre-investment
income, varied uses of component and composite depreciation
methods, the net capital gain provisions, the regular and
alternative minimum taxes, the maximum tax, depreciation
recapture, construction period interest and taxes, and the
tax rate schedule.

The study examined two types of new and used property,
two sets of actual tax provisions, two proposed tax changes,
three compounded annual rates of change for net operating
income and property value, two levels of taxpayer income,
three mixes of personal service and passive income and four
depreciation alternatives. The tax provisions specifically
directed toward low-income housing were not analyzed in this

study.

62

The conclusions drawn from this study can be summarized

as follows:

1. The net impact of the two Acts on many
investors is minor.

2. The Congressional intent expressed for these
Acts is not supported if the Acts are
considered collectively'rather than
individually.

3. The maximum allowable declining balance
depreciation yielded no appreciable advantage
over straight-line depreciation.

4. Significant increases in the rates of return
and decreases in optimal holding periods result

from the use of component depreciation.

The Dorr Dissertation

Dorr (1979) studied the impact of the TRA of 1976, the
RA of 1978, and other potential reform measures on
investments in typical real estate syndication activities.9
In addition to the above, other objectives included: (1) to
determine the differential impact of the above legislation
on investors with different income characteristics; (2) to
determine the impact of specific provisions included in the
above-mentioned legislation; and (3) to determine the
differential impact of the legislation on real estate

projects using alternative methods of depreciation.

 

63

A deterministic computer simulation model was
constructed to analyze two types of real estate-~a
residential rental and a commercial rental syndication.
Three levels were assigned to four parameters that included
the marginal tax rate, the percent of earned income, the
length of the investment period, and the assumed selling
price at the end of the investment period. This (along with
the depreciation parameters) produced 162 parameter sets
that were analyzed under 20 different tax structures.

The results pointed to the critical importance of
incorporating all the relevant tax laws into the model if
the investment return is to be adequately measured. The TRA
of 1976 was shown to have a material negative effect on the
profitability of real estate investments. The primary
factor causing the negative effect was the limitations
placed on "up-front deductions". Only taxpayers in
extremely low or high earned income groups were materially
affected by the changes in the maximum and minimum tax
rules. A somewhat surprising conclusion indicated that the
TRA of 1976 almost equated the returns of investors in
different earned income and marginal tax brackets. However,
the study does show that the RA of 1978 partially reversed
the TRA of 1976 and restored a differential return to
investors in different marginal tax brackets and with

different levels of earned income.

64

Summary

The above studies have analyzed several tax factors
with regard to a real estate investment. However, no
published research has addressed the four factors to be
analyzed in this study. There have been no comprehensive
tax analyses of the return available from an investment in
low-income housing, of the effects of the TRA of 1976 and
the RA of 1978 on the attractiveness of an investment in
low-income housing, of the differential advantage provided
for an investment in low-income housing, nor has there been
a comprehensive analysis of the effects of the ERTA of 1981
on real estate syndications.

This study will improve upon the methodology of the
previous studies and analyze four factors that have not
previously been scrutinized. The methodology and design of

the study is presented in the next chapter.

65

CHAPTER III FOOTNOTES

1William S. McKee, "The Real Estate Tax Shelter: A
Computerized Expose," Virginia Law Review (May, 1971), p.
521-573.

2 Edgar H. Hemmer, "How a Computer Thinks About Real
Estate," Real Estate Review (Winter, 1975), p. 113-123.

 

3 Grover A.<Zleveland. "The Impact of the Tax Reform
Act of 1969 Upon Investment in Real Estate" (Unpublished
IHLD. Dissertation, Indiana University, 1973).

4 Robert W. Wyndelts, ”Tax Planning and an Analysis of
Federal Income Tax Laws: Investment Decisions in Real
Estate" (Unpublished Ph.D..Dissertation, University of
Georgia, 1974).

5 U.S. Congressional Budget Office, Real Estate Tax
Shelter Subsidies and Direct Subsidy Alternatives,
Washington, U.S. Government Printing Office, 1977.

 

6 Ibid, p. 3.

7 Ibid, p. 3.

8 Jerrold J. Stern, "Tax Legislation of 1976 and 1978:
An Analysis of its Effects on the Rates of Return of Income-
Producing Real Estate" (Unpublished Ph.D. Dissertation,
Texas A & M University, 1979).

9 Patrick B. Dorr, "The Impact of the Tax Reform Act of
1976 and Other Proposed Legislation on Investment in Real
Estate Tax Shelters" (Unpublished Ph.D. Dissertation, North
Texas State University, 1979).

CHAPTER IV

RESEARCH METHODOLOGY AND DESIGN

Chapter IV describes the methodology of this study and
the two computer programs utilized to evaluate Section 8

investments.

Methodology

Two computer programs were written to evaluate the
impact of relevant tax law provisions on investments in
syndicated Section 8 housing organized and operated as
limited partnerships. This methodology, using a model to
represent abstractions of reality and provide an
understanding of key relationships, is known as simulation.
Specifically, simulation is used to derive solutions when
analytic and numerical solution methods are impractical.

Simulation studies also provide a means of Observing
the behavior of the components of a system under varying
conditions. No "solution", in the mathematical sense, is
sought; rather, the objective is to understand the
relationship among system components. By controlling
relevant parameters and variables, the model can be

manipulated to investigate the effects of changes in policy,

66

67

organization, methods, conditions, and relationships. A
decision in one part of the system often produces far-
reaching interactions in other parts of the system. A
simulation model assists in identifying these interactions
and in measuring their effects on the system. Hypotheses
can be formulated and tested using simulation models.
Decision rules and alternatives can be evaluated and
compared. The more important variables can be identified,
in terms of their interactions and effects on system
performance.

Simulation is an interactive process. The model-
building process may be subdivided into five steps:

1. Formulating the problem

2. Construction of a computer model representative of

the system under study
3. Model validation
4. Design of the study

5. Analysis of the results (presented in Chapter V)

Formulating the Problem
This phase establishes the scope of the model and the
modeling purpose. Chapter I sets forth the objectives,
scope, and data utilized in this study. The overall
Objective of this study is to provide a framework for
assessing the use of the tax law to encourage investment in

low-income housing. However, this objective, by itself, is

68

too broad to lead to any specific model formulation. It
does not specify the tax provisions that fall within the
scope of assisting Section 8 low-income housing. This in
turn leads to a question of the specifics of these
provisions and how they have evolved- An additional
consideration is the specification of the criteria used to
measure the impact of the tax law changes on the investors
in Section 8 housing.

An important result of the above formulation is the

specification of the four detailed objectives of this study:

1. To determine the extent to which an investor's
expected return from low-income housing differs
from his actual return.

2. To determine the relative impact of the tax
legislation (referred to in Chapter II) on
investment returns earned in low-income housing
syndications by investors with different
characteristics (i.eq. marginal tax rate,
investment holding period).

3. To determine the impact of the ERTA on expected
returns for an investment in low-income housing.

4. To investigate the differential impact of the
provisions specifically enacted to provide an

incentive for investment in low-income housing.

69

Construction of a Computer Model
Representative of the System Under Study

After specifying the purpose of a study, it is
necessary to describe the system in terms amenable to a
general form of model construction and, ultimately, to a
solution method. This entails identifying all the tax
provisions which would materially impact either the real
estate projects being evaluated or the investors and
properly reflecting the relationships between these
provisions. A complete description of the computer models
developed is presented later in this chapter. In general,
the models contain the following features, common to
simulation models:

1. Components

2. Variables

3. Parameters

4. Relationships among components and variables

Components are those entities of a system that are
independently identified and whose collective performance
determines the output of the system. The individual
performance of each component is a random variable, as is
the performance of the total system. Variables are those
attributes of the system that take on different values under
different conditions or in different system states.
Variables can be classified as independent and dependent.
Independent variables are those that the experimenter is

free to manipulate, such as levels of a factor. Dependent

70

variables are those whose values result from the
manipulation of the independent.(or controllable) variables
within the system.

Parameters are those attributes of the system that do,
not change as a result of anything that occurs during the
simulation. Parameters may be changed during a simulation,
but only at the Option of the experimenter. Relationships
in a system are those connections between components,
variables, and parameters that control the state of change
in the system. Relationships specify how the values of
different variables in the system are related to each other

and to the parameters of the system.

Model Validation

"Internal validity is the basic minimum without which
any experiment is uninterpretable: Did in fact the
experimental treatments make a difference in this specific
experimental instance?"l In this study, internal validity
was tested through detailed analyses of the program.
Representative sample data were utilized in each program to
test the validity of the program and each subroutine. Print
statements, added to the programs at various locations,
caused the values of all significant variables and
parameters to be printed for each year of the sample data.
Each sample calculation was reperformed manually and

compared with the sample output.

71

"External validity asks the question Of
generalizability: To what populations, settings, treatment
variables, and measurement variables can this effect be
generalized?"2 To insure the internal and external validity
of the models, the following steps were taken: UJ a review
of real estate syndication prospectuses and offering
circulars for commercial, residential, and government-
assisted real estate projects, (2) an in-depth review of
books and journal articles that relate to real estate
operations and taxation. (3) a thorough review of relevant
Internal Revenue Code provisions, Treasury regulations, and
IRS rulings relating to partnership and real estate
taxation, and (4) interviews concerning the Operating,
financing, and taxation of Section 8 housing syndications
with property managers, representatives of MSHDA, and
knowledgeable CPAs. A final step in the validation process
was to review the output, the various measures of
profitability, for illogical or inconsistent results. An
example of this is a change in one variable for which the
direction of change was logically determinable, where the
predetermined direction of the output could be compared with

the actual computer output.

Design of the Study
At this step of the model-building process the items
treated as factor variables, response variables, and

parameters are identified. The term "variable" indicates an

72

attribute of interest which may assume different values for
different computer runs. Changing the value of one of these
variables creates a new investor profile for which
profitability measures are computed. In this study the
factor variables have previously been identified while the
response variables are the various measures of return to be
generated by the computer programs.

The parameters do not change during the simulation
because of anything that occurs during the simulation. They
strengthen the validity and increase the precision Of the
model, but are not treated as variables which measure the
effect of the changes.

The taxpayer variables examined in this study were
selected with the Objective of determining the differential
impact of the 1976, 1978, and 1981 tax legislation on the
resulting investor profiles. The taxpayer variables
identified as significantly affecting a Section 8 housing

investor's return are presented in Figure 4.

 

Marginal Tax Rate

Tax shelters permit taxpayers to reduce or eliminate
tax liability on their economic incomes by utilizing
preferential provisions in the tax law. However, the
benefits obtainable are directly related to the taxpayer's
marginal tax rate. The higher the marginal rate, the
greater the tax savings resulting from offsetting losses

against taxable income from other sources. Securities and

73
Exchange Commission (SEC) guidelines, tax and investment
advisors, and investment prospectuses usually state that
investors in Section 8 housing should expect to be subject
to a marginal tax rate of at least 50 percent over the life
of the project. Therefore, this study evaluates each
Section 8 investment (except those evaluated under post-1981
law where the maximum marginal rate is 50 percent) at three
marginal tax rates: 50, 60, and 70 percent. This allows for
the evaluation of the extremes in marginal rates as well as
a middle figure.

Because income tax brackets are often not wide enough
to accomodate the taxpayer's entire share of loss, a model
assuming static marginal rates could produce misleading
results. This study does not rely on a single marginal tax
rate for each investor profile. Actual tax rates for the
various years under study are utilized. The taxpayer's
taxable income is set at a level such that, after the
initial years' large losses (i.e~, after four to five
years), the resulting taxable income falls into
approximately the middle Of the tax bracket under scrutiny.
This results in some early year losses producing tax savings
at less than the prescribed marginal tax rate and in some
later year losses producing tax savings at more than the
prescribed marginal tax rate. All 70 percent investor
profiles were assumed to have sufficiently high taxable
income, without the loss, so that the entire loss produced a

70 percent tax savings unless the maximum tax on PSI

74
aipplied. In this instance, the tax savings range from a low

<>f 50 percent to a high of 70 percent.

IPersonal Service Income 5 3 Percent g£_Taxable Income

 

This study analyzes the impact of varying levels of
19ersonal service income (PSI) relative to taxable income
(for investments analyzed under pre-1982 tax law). The
purpose of this variable is to identify the effect of the
maximum tax provisions on the tax savings of the various
investor profiles. The analyses performed utilizing pre-
ERTA law assume three different levels of PSI relative to
the taxpayer's taxable income prior to any income or loss

from the Section 8 investment: 20, 50, and 90 percent.

Tax Preference Items

A third variable which impacts the return of an
investor in Section 8 housing is the amount of tax
'preference items utilized by the taxpayer to reduce taxable
income. The purpose of this variable is to identify the
(effect Of the minimum tax provisions on the tax savings of
'the various investor profiles. For purposes of the
alternative minimum tax, the only preference is assumed to
Ibe the net capital gain deduction resulting from the sale of
‘the investment at the end of the holding period. For
purposes of the add-on minimum tax, two levels of
preferences were assumed: (I) the investor's tax
preferences were average for a taxpayer with this profile

(which may or may not result in an add-on minimum tax), and

75
(2) all of the preferences arising from the investment in
£5ection 8 housing were subject to the add-on minimum tax (an
add-on minimum tax was forced).
The investment variables affecting an investor's return
from a Section 8 housing investment are: (1) length of the
.investor's holding period, and (2) the assumed selling price

of the investment at the end of the holding period.

Investment Holding Period

Three holding periods--nine, 12, and 15 years--were
utilized in the study because of the significance of these
dates for cost recovery and depreciation recapture purposes.
Nine years was chosen because it is the approximate
beginning of the phase-out under the 200 month rule (the
amount of excess cost recovery to be recaptured is 100
percent less one percent for each month of the holding
period in excess of 100 months). The 15 year variable was
selected because (under the ACRS) the basis of real property
is recovered over a 15 year period. If an investor retains
his interest at the end of this period, the shelter arising
from cost recovery deductions is fully utilized. At this
point, the investor will normally sell his interest or
otherwise attempt to restore some tax shelter, such as
through refinancing. Furthermore, at the end Of this period
straight-line and accelerated cost recovery will be equal.
Thus no recapture of excess cost recovery deductions will be

required. The 12 year level was chosen as a middle figure

76

between the extremes of virtually complete recapture of

excess cost recovery deductions and no recapture.

Investment Selling Price

The ultimate selling price of the investment has an
impact upon the investor's return. The amount of gain
recaptured as ordinary income and the cash available (if
any) to the investor at the end of the holding period are
two significant return factors affected by this variable.
Three selling prices were selected: NJ the remaining
mortgage balance, (2) the original development cost of the
property, and C” the original development cost plus three
percent annual appreciation. The remaining mortgage balance
level assumes the investor "walks away" from the investment
because it is no longer providing shelter for his other
income or simply because he cannot find someone to purchase
his interest. The gain or loss produced by walking away is
equal to the difference between the investor's share of the
remaining mortgage balance (sales price) and his adjusted
basis for his partnership interest. The choice of three
percent appreciation reflects the relative illiquidity of
the investment and the limited appreciation potential of
this type of housing as suggested by numerous authors and
tax specialists. Once again the choice of the original
development cost reflects a middle ground intended to fall
between the two extremes (as defined in this study) of

"walking away" or a modest appreciation in value.

77
The following legislation variables were treated as
independent variables in the models to determine the impact

of tax expenditures on the investor profiles.

Construction Period Interest and Taxes

 

 

The TRA of 1976 specified that real property
construction period interest and taxes be capitalized in the
year in which paid or accrued (depending upon the taxpayer's
method of accounting). A portion of the amount capitalized
may be deducted in that taxable year with the balance being
amortized beginning in the year the property is placed in
service.

Construction period interest includes interest paid or
accrued on indebtedness incurred or continued to acquire,
construct, or carry real property to the extent attributable
to the construction period for such property. The
construction period commences with the date on which the
construction of a building or other improvement begins and
ends on the date that the building or improvement is ready
to be placed in service or held for sale.

Separate transitional rules were provided for
nonresidential real estate, residential real estate, and
(government subsidized housing. In the case of residential
real estate (other than low-income housing) this provision
‘was to apply to construction period interest and taxes paid
or accrued in taxable years beginning after 1977 and, in the
case of low-income housing, to construction period interest

and taxes paid or accrued in taxable years beginning after

78

:L.981. However, the ERTA of 1981 amended Section 189 to

};>rovide that it will not apply to low-income housing.

C ost Recovery Recapture

In the TRA of 1969, the recapture rules for real

p>roperty were modified as to post-1969 depreciation. In the

<:ase of residential real property, post-1969 depreciation in

eexcess of straight-line is fully recaptured at ordinary
:income rates (to the extent of the recognized gain) if the
property has been held for more than 12 months but less than
100 months. For each month the property is held over 100
Inonths, there is a one percent reduction in the amount of
'post-1969 excess depreciation recaptured. Thus there is no
recapture of excess depreciation if the property is held for
at least 200 months.

In the TRA of 1976 Congress provided that, in the case
of residential real estate (other than low-income housing),
aall post-1975 depreciation in excess of straight-line is to
Ibe completely recaptured. This provision applied regardless

of the date on which depreciation commenced. For low-income
housing, the Act provided that for each month the property
was held over 100 months, there is a one percent per month
reduction in the amount of recapturable excess depreciation
attributable to periods after 1975. Although the ERTA of
1981 significantly affected the potential excess cost

recovery to be recaptured (by providing for 175 DB or 200 DB

cost recovery over 15 years), the TRA of 1976 differential

79
Zt>etween residential (100 percent recapture) and low-income

‘rlousing (200 month rule) was not changed.

The ERTA of 1981 introduced a new capital cost recovery
ssystem for tax purposes (Code Sec. 168), which replaced the
(:LADR and facts and circumstances depreciation methods for
Inost tangible depreciable property placed in service after
1980. Under the ACRS, virtually all tangible depreciable
jprOperty is depreciated by applying a statutory fixed rate
for a statutory-determined recovery period. This annual
cost recovery allowance replaces the annual depreciation
deduction allowed under Code Section 167.

The ACRS established five categories of recovery
property:

1. 3-year Property

2. 5-year Property

3. 10-year Property

4. 15-year Public Utility Property

5. lS-year Real Property

Thus depreciable prOperty, whether new or used, is
assigned to one of the five recovery periods. The
accelerated statutory rate for most real property in the 15-
year class is 175 DB. However, the 200 DB method is
available for low-income housing. The IRS has issued two
rate tables (Figures 2 and 3) which reflect the above
declining balance methods with appropriately-timed switches

to straight-line to maximize the recovery deduction.

80

 

Percentage Based on Month Placed in Service

8.

7.

6.

5.

4.

3.

2.

1.

 

1.209876665555555
11

2.109876666555554
1.1.

31.001876665555554
11.1.

4.109876655555554.
1.1.

5109876655555553
1.1.

61.098765555555513
11.1.

71.08776665555557—
1.1

8108776655555552
1.1..

9198766666555551
1.

98766666555551.

10
11

9876666655555—

11
10

9:87:6QORVGPDRJSZDRJS _

12
10

 

Recovery

 

Year

1234567890123456
1.111.111

 

 

1

ACRS Percentages for All Real Estate (Except

Low-Income Housing)

Figure 2.

81

 

Recovery
Year

 

\DmflmmbWNi-J

 

 

Percentage Based on Month Placed in Service
lazséézgzlgg
13 12 11 10 9 8 7 6 5 4 3
12 12 12 12 12 12 12 13 13 13 13
10 10 10 10 11 11 11 11 ll 11 11
9 9 9 9 9 9 9 9 10 10 10
8 8 8 8 8 8 8 8 8 8 8
7 7 7 7 7 7 7 7 7 7 7
6 6 6 6 6 6 6 6 6 6 6
5 5 5 5 5 5 5 5 5 5 6
5 5 5 5 5 5 5 5 5 5 5
5 5 5 5 5 5 5 5 5 5 5
4 5 5 5 5 5 5 5 5 5 5
4 4 4 5 4 5 5 5 5 5 5
4 4 4 4 4 4 5 4 5 5 5
4 4 4 4 4 4 4 4 4 5 4
4 4 4 4 4 4 4 4 4 4 4
- - l l 2 2 2 3 3 3 4

 

fibbmmmmmmquo

 

Figure 3.

ACRS Percentages for Low-Income Housing

 

82

The major objective of this study is to provide a
framework for assessing the use of the tax law to encourage
investments in low-income housing. The two computer
programs utilized to accomplish this objective incorporate
(where applicable) the relevant provisions of pre-TRA of
1976 law, the TRA of 1976, the RA of 1978, the ERTA of 1981,
and the above legislation variables. To accomplish this
objective, six pre-TRA of 1976 Section 8 projects with
actual results through 1981 were evaluated under three tax
structures:

1. Pre-l976 projections with the law as it existed
prior to the TRA of 1976.

2. Actual results through 1981 for number one above
with projection and the tax law as it existed
prior to the TRA of 1976.

3. Actual results through 1981 for number one above
with projection after incorporating the tax law
changes made by the RA of 1978 and the ERTA of
1981.

Twelve 1981 Section 8 projects were evaluated under

nine tax structures:

1. The original projections with the tax law as it
existed prior to the ERTA of 1981.

2. A revision of number one above to incorporate
the amendments of the ERTA of 1981.

3. A revision of number one above to incorporate

the amendments of the ERTA of 1981 and further

83
revised to incorporate 175 DB cost recovery.
A revision of number one above to incorporate
the amendments of the ERTA of 1981 and further
revised to incorporate the capitalization and
amortization of construction period interest and
taxes.
A revision of number one above to incorporate
the amendments of the ERTA of 1981 and further
revised to incorporate 100 percent recapture of
all excess recovery deductions.
A revision of number one above to incorporate
the amendments of the ERTA of 1981 and further
revised to incorporate 175 DB cost recovery and
the capitalization and amortization of
construction period interest and taxes.
A revision of number one above to incorporate
the amendments of the ERTA of 1981 and further
revised to incorporate 175 DB cost recovery and
100 percent recapture of all excess recovery
deductions.
A revision of number one above to incorporate
the amendments of the ERTA of 1981 and further
revised to incorporate the capitalization and
amortization of construction period interest and
taxes and 100 percent recapture of all excess

recovery deductions.

84

9. A revision of number one above to incorporate
the amendments of the ERTA of 1981 and further
revised to incorporate 175 DB cost recovery, the
capitalization and amortization of construction
period interest and taxes, and 100 percent
recapture of all excess cost recovery
deductions.

Figure 4 presents an overview of the experimental
design of the study indicating the taxpayer, investment, and
legislation variables and the values assigned to these
variables. The Figure also summarizes the 12 tax structures
assumed in the analyses. Together, these variables formed
either 162 (pre-TRA Section 8 Projects) or 486 (1981 Section
8 Projects) investor profiles. The following profitability
measures were generated: (1) the payback period (PB), (2)
the average rate of return (ARR), and (3) a profitability
index (PI).

While the first two measures ignore the time value of
money, all three measures of return are used extensively in
real estate analysis. Their use corresponds with a 1976
study which indicated that only 25 percent of real estate
investors utilize time value measures of return.3 That
study found that the most frequently used measure was the
ARR.

Two assumptions were made regarding the timing of the
tax savings. First, this study assumes that most investors

in Section 8 housing make estimated tax payments on a

 

Taxpayer
Variables

85

 

 

 

Marginal
Tax Rate

 

1. 70 percent
2. 60 percent
3. 50 percent

Personal
Service

Income as a
Percentage of
Taxable Income

Investment
Variables

 

 

 

l. 90 percent
2. 50 percent
3. 20 percent

Tax Preference
Items

1. All Taxable
2. Average for
Taxpayer
with this
Income
Level

 

 

 

Figure 4.

Investment
Holding Period

 

1. 15 years
2. 12 years
3. Nine years

Investment
Selling
Price

1. Three
Percent
Appreciation

2. No
Appreciation

3. Mortgage
Balance

Legislation
Variables

 

 

 

 

Summary of Variables

l. Capitalize
Construction
Period
Interest and
Taxes
(C.P.I.& T.)

2. Revise Cost
Recovery
Method
(200 DB to
175 DB)

3. 100 percent
Recapture of
Excess Cost
Recovery
Deductions
(Recap)

 

 

86

quarterly basis in addition to any amounts withheld by an
employer. Secondly, the investor factors the tax loss from
the Section 8 investment into the quarterly estimated tax
payment. Therefore, the tax savings are assumed to occur on
a quarterly (rather than an annual) basis.

The payback period utilized in this study is a non-
present value technique which computes, to the nearest
quarter, the time it takes to recover the cash invested.

The average rate of return represents the undiscounted
quarterly cash flow from the investment divided by the
investor's cash investment. The profitability index
computed in this study is the ratio of the present value of
the quarterly tax savings, distributions to the investor and
cash received on sale (if any) over the present value of the
investment.

The internal rate of return is that discount rate which
equates the present value of the expected cash outflows with
the present value of the inflows. However, under certain
conditions, multiple solutions may occur. The following
equation illustrates this point:

NPV = CFl/(1+r)1 + CF2/(1+r)2 +...+ CFN/(1+r)N 4

This formula is a polynomial of degree N. Thus there
are N roots for the equation. In the usual case where the
internal rate of return is utilized--one or more cash
outflows followed by a series of cash inflows-~only one
positive value for r results. However, when an investment

involves one or more cash outflows over its life, the

87

possibility of multiple or only negative and imaginary roots
arises.

All of the Section 8 projects examined in this study
space the investor's cash investment over a four to six year
period. As a result, a net cash outflow occurred
approximately every fourth quarter for up to the first two-
thirds of the investment holding period. This resulted in
multiple, negative and imaginary roots for the polynomial.

As an alternative, Mao suggests graphing the polynomial
and determining the point at which the function changes from
a positive to a negative NPV.5 Several graphs of the
continuous functions were prepared, but in all instances
(over a relevant range of 0 to 100 percent) the functions
failed to change from positive to negative. Therefore, no
real roots could be determined within the relevant range.

As a result, only three measures of return (the PB, the ARR,
and the P1) are utilized as a means of analyzing the stated

objectives of this study.

Model Description
The simulation models utilized in this study are two
computer programs consisting of a main program and four
subroutines. The main program performs the basic Operations
involving the computation of the results of Operations, the
cash flows, and the measures of return for the investment.
The four subroutines produce successively the ordinary

income tax with and without the investment, the maximum tax

88

with and without the investment, the minimum tax with and
without the investment, and the gain and depreciation
recapture figures that were utilized to determine the tax
and cash flows in the year of disposal. An overview of the

computer models is presented in Figure 5.

Description of Input
The values for the investment variables were
interactively entered into the program. An input form, an
example of which is shown in Figure 6, was designed to
gather the necessary data.

The investment variables utilized in program input

included:

1. Years to date of sale--This input represents
the length Of time in years between the initial
investment and the year of sale of the project.
Since the intent of using this variable was to
test the parameters of the recapture and cost
recovery provisions (exy, 100 months and 15
years), the actual values utilized in this
study were 10, 13, and 16 years. These holding
periods were utilized because, in all of the
projects, no depreciation was claimed until
year two when the project was actually placed
into service. Thus to test the approximate
upper and lower bounds of the recapture

provisions, one year was added to the actual

 

C Start 3
l

 

G

Figure 5.

 

 

 

 

 

 

 

10

 

 

W
F_1_

.3

 

(

ll

 

 

 

 

 

LL

 

 

 

 

.1_,

5

 

 

 

 

12

 

 

 

 

 

13

 

 

 

 

2
4
6

 

 

[—1—

 

 

14

 

 

 

 

 

 

 

 

l6

 

 

 

 

 

 

 

 

 

Y
19

Program Flowchart (legend on next page)

 

18

 

 

10.
ll.

12.

13.

14.

15.

16.
17.

18.
19.

90

Input.

Determine regular income tax liability on taxable
income without an investment in Section 8 property
(regular computation or with income averaging).
Add alternative or add-on minimum tax, if applicable.
Determine regular income tax liability utilizing
the maximum tax on taxable income without an
investment in Section 8 property. Does not apply to
years subject to 1982 or later tax law.

Add alternative or add-on minimum tax (to tax
determined in number 4), if applicable.

Determine lowest tax liability from above (number 3
or 5).

Determine regular income tax liability on taxable
income adjusted for partnership income or loss and
gain or loss on sale, if applicable.

Add alternative or add-on minimum tax (to tax
determined in number 7), if applicable.

Determine regular income tax liability utilizing
the maximum tax on taxable income adjusted for
partnership income or loss and gain or loss on
sale, if applicable. Does not apply to years
subject to 1982 or later tax law.

Add alternative or add-on minimum tax (to tax
determined in number 9), if applicable.

Determine least tax liability from above (number 8
or 10).

Subtract smallest tax liability without the
investment (number 6) from smallest tax liability
after adjustment for partnership results (number
11) to determine tax savings (additional tax) due
to investment.

Apportion tax savings (or additional tax liability)
over the number of quarters in the year.

Apportion partner's share of cash from sale (if
applicable) and the yearly cash distribution (if
any) to the last quarter of the year. Correct any
quarter cash flow to reflect an investment when
made.

15 the investor's holding period complete (iJL,
year of sale)?

Compute measures of return.

Computation completerfor all levels of all
variables for this Section 8 Project?

Initialize and increment one level of one variable.
End.

Figure 5. Legend

QWNH

\lmU‘

91

Years to date of sale:

 

Mortgage balance at date of sale:

 

Original cost of the project:
Percent of ordinary income, loss,
Operating cash flow, and proceeds
of sale accruing to the partner:

 

Limit on cash distribution:
Original mortgage balance:
Cash invested by quarter of investment:

8. Number of quarters in year one:
9. Year investment begins:

10. Rental Cash Noncash Nontax Tax
Income Deduct Deduct Cashflw Prefs.
1)

1)
2)
3)
4)
5)
6)

Recap-
ture

Spec.
Alloc.

 

2)

 

3)

 

4)

 

5)

 

6)

 

7)

 

 

8)

 

9)

 

10)

 

11)

 

12)

 

13)

 

14)

 

15)

 

l6)

 

Figure 6. Input Form

92

year of interest (iAL, a holding period of 10
years was utilized to obtain nine years of
depreciation).

Mortgage balance at date Of sale--All of the
prospectuses provided data on the mortgage
balance at the end of each year for the first
20 or 25 years of the investment. The balances
entered were taken directly from this data at
the end of the 10th, 13th, and 16th years.
Original cost of the project—~All Of the
prospectuses provided a figure for the total
development cost of the project as defined by
MSHDA. MSHDA provides a mortgage for up to 90
percent of this amount. This figure was
utilized as the original cost of the project.
Percent of ordinary income, loss, Operating
cash flow, and sales cash flow accruing to the
individual partner--These numbers were provided
in the partnership papers for each of the
Section 8 projects examined in this study.
Limit on cash distribution--As previously
explained, HUD and MSHDA regulations place a
limitation on the amount of cash dividends that
a Section 8 Project may distribute to its
partners. This figure is taken directly from

the prospectus for each of the projects.

10.

ll.

12.

93

Original mortgage balance--This figure comes
directly from the prospectus for each project
and affects the partner's adjusted basis for
his partnership interest.

Cash invested by quarter of investment-~This is
the individual partner's cash investment as
provided for in the prospectus. Input of the
quarter in which the investment is made affects
the discounting for purposes of computing the
PI.

Number of quarters in year one--Many of the
Section 8 Projects examined began with an
initial investment by the partner in the fourth
quarter of the year. This input establishes
the number of quarters over which the initial
year tax savings were spread.

Year investment begins--This input was utilized
to select the proper tax structure for each
year of the investment and to provide the base
period for all discounted cash flows.

Rental income--This input represents the
project's actual cash inflow for the year.

Cash deductions--This input represents the
projectfs actual yearly cash outflow deductible
for income tax purposes.

Noncash deductions--This input represents the

project's deductible expenses that required no

94

cash outflow (i&L, depreciation and
amortization).

13. Nontax cash flow--This input represents the net
cash inflow or outflow that does not affect the
tax consequences of the project (iJL,
principal amortization and partner investment).

14. Tax preferences--This is the amount of the tax
preference for each year primarily attributable
to the use of an accelerated method of cost
recovery on real property.

15. Recapture--This is similar to the tax
preference input (above) except that it is
entirely attributable to excess cost recovery
and reflects the decline in the recapture
potential through negative entries as the
accelerated cost recovery amount falls below
the hypothetical straight-line cost recovery.

16. Special allocations--Several of the Section 8
projects singled out specific amounts (none of
which represented cash flows) to be allocated
to the limited partners on a basis other than
their profit and/or loss sharing ratio. These
amounts were removed from any other entry to
which they otherwise belonged and specifically
allocated to the limited partners.

The only taxpayer variable not built into the program

was the partner's taxable income prior to investing in the

95

Section 8 Project. This was manually entered to control the
tax bracket into which the investor fell.

As seen in Figure 7, the main program consists of five
major sections. The return on syndicated real estate
investment arises primarily from three sources: (1) a
distribution of cash from operations (subject to HUD and
MSHDA regulations), (2) cash flow from tax savings, and (3)
cash flow from the disposition of the property. The
computation of these cash flows is accomplished by three of
the five sections of the main program. The two remaining
sections generate the operating results and taxable income
and the measures of return that result from the changes in
the variables outlined earlier in this study.

The four program subroutines provide input for
computations made in one of the five sections of the main
prograflh The following is a brief description of each
subroutine:

1. Subroutine One--This subroutine contains the

regular income tax rate schedules for the years
1976 through 1984. The 1984 rates are assumed
to apply to all taxable years after 1983 unless
the computations were based on pre-TRA of 1976
law. Subroutine One calculates the normal tax
liability based on the investor's taxable
income, both with and without the Section 8

loss, for the current and, if advantageous,

96

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

4
J
3-. 3
6
N J
Y
L N 7|
_____JL_____
8
.L
9 12
l N
‘
10 V

 

Figure 7. Main Program and Subroutines (legend on next page)

mummb w
o. oo o

9.

10.
11.
12.

13.

97

Input.

Determine results of partnership operations,
project cash flow, investor's basis in partnership,
and tax loss to be al located to partner.
Determine partner's tax savings (additional
liability) from the investment.

Subroutine One.

Subroutine Two.

Subroutine Three.

Subroutine Four.

Determine investor's cash flow from project
distributions.

Determine investor's cash flow from sale of project
(if any) when holding period is complete.

Compute measures of return at end of holding
period.

Computations complete for all levels of all
variables?

Increment one variable and recompute based on new
investor profile.

End.

Figure 7. Legend

98
the four prior taxable years (income
averaging).

2. Subroutine Two-~This subroutine calculates the
maximum tax on personal service income. The
actual computation of this amount is a function
of the tax law applicable to that particular
year. To avoid duplication, it accesses
Subroutine One where necessary to utilize the
tax rate schedules.

3. Subroutine Three-—This subroutine calculates
the add—on and the alternative minimum tax
(when applicable). The actual computation of
these amounts is a function of the tax law
applicable to that particular year.

4. Subroutine Four--This subroutine is accessed in
the year of sale to determine the net capital
gain on sale, amount of excess cost recovery
recaptured as ordinary income, and the cash
available:(if any) to the investor on the sale

of the investment.

Description of Output
The program output, as shown in Figure 8, presents the
results for 54 investor profiles on each page. In addition
to listing the results for the payback, the average rate of
return, and the profitability index, each line of output

also indicates the value for the investment selling price

99
(SPRICE), the holding period in years (A(A)), the amount of
taxable income (C(C)), and indicates whether the minimum tax

was forced (B). These variables were summarized in Figure 4.

SPRICE
5362063

9315356

6931500

5619073

10179141

6931500

5236572

111230

f)
h)

6931500

Figure 8.

ACA)
10
10
10
10
10
10
10
10
10
10
10
10
10
10
10
10
10
10
13
13
13
13
13
13
13
13
13
13
13
13
13
13
13
13
13
13
16
16
16
16
16
16
16
16
16
16
16
16

16

16
16

16

Example of Output

C(C)
65000
65000
110000
110000
250000
250000
65000
65000
110000
110000
250000
250000
65000
65000
110000
110000
250000
250000
65000
65000
110000
110000
250000
250000
65000
65000
110000
110000
250000
250000
65000
65000
110000
110000
250000
250000
65000
65000
110000
110000
250000
250000
65000
65000
110000
110000
250000
250000
65000
65000
110000
110000
250000
250000

NHPJHI‘JHNF‘I‘JPPJPfJHfJO-‘PJHl‘JHNPNHNO-‘NHNHVJHNHFJHPJHNPI‘JHFJPNHNHNHNHIJHN

100

P3
34
33
29
30
24
26
34
33
29
30
24
26
34
33
29
30
24
26
34
36
29
30
24
26
34
36
29
30
24
26
34
36
29
30
24
26
34
36
29
30
24
26
34
36
29
30
24
26
34

29
30
24
26

ARR
7.11
6.3
8.27
8.09
9.97
9.09
16.06
15.76
17.19
17.01
18.00

9.33
9.53
11.04
10.36
12.73
11.35
6.96
6.73
3.04
7.91
9.51
3.34
15.95
15.72
16.99
16.35
13.45
17.79
9.54
9.32
10.62
10.43
12.03
11.42
6.46
6.27
7.46
7.35
3.77
3.23
15.73
15.54
16.69
16.53

17.46
9.07
3.39
10.06
9.95
11.37
10.33

COOOOOOOOOOOOOOOOODODOOQO6°0°ODOOOOOOOOOOOOOOOOQODOOOOH

PI
0.63
0.61
0.73
0.71
0.35
0.73
0.35
0.32
0.95
0.93
1.06
0.99
0.7
0.67
0.3
0.73
0.92
0.34
0.71
0.69
0.32
0.31
0.95
0.33
0.33
0.35
0.99
0.97
1.11
1.04
0.76
0.74
0.37
0.35
0.99
0.92
0.76
0.73
0.37
0.35

0.93
0.33
0.35
0.99
0.97
1.12
1.05
0.79
0.77
0.91
0.39
1.03
0.96

101

CHAPTER IV FOOTNOTES

1 Donald.Tu Campbell and Julian C. Stanley,
Experimental and Quasi-Experimental Designs for Research

(Chicago: Rand McNally, 1963), p. 5.
2 Ibid.

3 Robert J. Wiley, "Real Estate Investment Analysis: An
Empirical Study," The Appraisal Journal, 44 (October, 1976),
p. 589.

4 NPV is the abbreviation for net present value, CF for
cash flow, and r for the discount rate.

5 Cho-tiing Mao, Quantitative Analysis 9: Financial
Decisions (New York: Macmillan, 1969), p. 76.

 

CHAPTER V

RESEARCH RESULTS AND CONCLUSION

The models described in Chapter IV were utilized to
evaluate the impact of the TRA of 1976, the RA of 1978, and
the ERTA of 1981 on investments in Section 8 housing. As
described earlier, for each pre-TRA of 1976 investment
evaluated, 162 unique investor profiles were produced by
allowing three possible values for the marginal tax rate,
personal service income (PSI) as a percentage of taxable
income, investment holding period, and the selling price of
the property. .Additionally, two levels of tax preference
items were assumed for both the maximum and the add-on
minimum tax.

For each 1981 Section 8 project evaluated, 486 unique
investor profiles resulted from: (1) eliminating the
variable for PSI as a percentage of taxable income (since
the maximum tax was eliminated by the ERTA of 1981) and, (2)
by adding the following legislation variables and their
interactions: capitalization and amortization of
construction period interest and taxes, a revision of the
cost recovery method from 200 DB to 175 DB, and a revision
of the recapture method to one that recaptures all excess

cost recovery deductions.

102

103

The following return measures were produced for each
parameter set: profitability index (PI) based on a 20
percent discount rate, undiscounted average rate of return
(ARR), and payback (PB). These return measures were then
averaged across the levels of the variables noted above.

The results are presented in this chapter.

Projected Versus Actual Results and
the Impact of Post-1975 Tax Reforms

The research results demonstrating the effects of the

actual versus the projected results and the impact of the
post-1975 tax reforms on the measures of return are
presented below in six sections: .UJ the overall impact,
(2) the impact by marginal tax rate, (3) the impact by
percentage of PSI, (4) the impact of the add-on minimum tax,
(5) the impact of the length of the investor's holding
period, and (6) the impact of the ultimate selling price.
These results address the following two objectives of this
study:

1. To determine the extent to which an investor‘s
expected return from low-income housing differs
from his actual return.

2. To determine the relative impact of the tax
legislation (referred to in Chapter II) on
investment returns earned in low-income housing

syndications by investors with different

104

characteristics (i.eq. marginal tax rate,

investment holding period).

Overall.Impact

The use of actual results versus the use of the initial
projections revealed a significant difference in all but one
measure of return. These results are presented in Table 1.

The results indicate the effect of the actual and
projected results averaged across the following variables:
marginal tax rate, PSI as a percentage of taxable income,
the results with and without a forced add-on minimum tax,
the investment holding period, and the selling price of the
investment.

A comparison of the actual results without the post-
1975 tax reforms and the original projections revealed that
the PI had declined 15.28 percent. The use of actual
results with the post-1975 tax reforms revealed an 18.53
percent decrease in the PI over the initial projections and
a 3.83 percent decrease relative to the actual results
excluding any post-1975 tax reforms.

A comparison of the actual results without the post-
1975 tax reforms and the original projections revealed that
the ARR had declined by 21.95 percent. The use of the
actual results with the post-1975 tax reforms also resulted
in a 20.27 percent decrease in the ARR when compared to the
original projections. However, a comparison of the actual

results with and without the post-1975 reforms indicates

105

Table 1. Summary of Overall Results
Pre-TRA of 1976 Section 8 Housing

 

Structure
Without Tax Reforms With Tax Reforms
Percent Percent Percent
Original Change Change Change
Return Projected Actual From Actual From From
Measure Results Results Column 1 Results Column 1 Column 2
(1) (2) I (3) (4) I (5) I (6)
PI 1.263 1.070 -15.28* 1.029 ~18.53* -3.83*
ARR 14.437 11.268 -21.95* 11.511 -20.27* +2.16
PB 16.194 35.704 +120.48* 39.333 +142.89* +10.16*

 

 

 

* Significant at a = .02

Units:

PI--— A PI of one is equivalent to a ful 1 recovery of the present
value of the cash investment. A P1 in excess of one is
equivalent to a recovery of more than the present value
of the cash investment.

ARR--This measure is stated in percentage terms.

PB-- This measure indicates the number of quarters the partner-
ship interest must be held to recover the cash investment.

 

 

106

that the ARR increased by 2.16 percent. While this
difference was not significant, it does indicate an
inconsistency in results between those measures that
consider the time value of money and those that do not.

The use of actual results without the post-1975 tax law
reforms increased the PB by 120.48 percent over the use of
the initial projections. The actual results incorporating
the post-1975 tax reforms also increased the PB by 142.89
percent over the initial projections without the reforms and
by 10.16 percent over the actual results without the tax
reforms.

This indicates that the initial projections did not
reasonably portray the return an investor might expect. The
overriding factor in this result is the projectionls
inability to predict future financial events in the rental
market and the substantial increase in rental income
authorized by HUD for Section 8 projects during the highly
inflationary 1978-1982 period. These increased rents
substantially reduced the taxable loss incurred by the
investments while at the same time providing the funds
necessary to pay the maximum authorized cash dividend to the
investors. Because of the limited nature of this direct
cash return (generally six percent of the initial
investment), investors must look to the tax losses produced
by the investment for the bulk of their return. Thus the
smaller than projected tax losses significantly reduced the

investor's return.

107

The PI and the PB both indicate that the post-1975 tax
reforms had a substantial impact on the return of investors
with existing investments in pre-TRA of 1976 Section 8
housing. Although these measures show significant return
differentials after the tax reforms, the change in the ARR
(with post-1975 tax reforms) was not significant and
actually showed a small increase. This increase arose
primarily from the net effect of the TRA of 1976 and later
tax reforms which decreased up-front deductions. The
reforms, therefore, reduced early year losses with the
deferred expenses utilized to reduce taxable income in later
years. Because the losses are more evenly distributed over
the investment period, on average they produce larger
nominal tax savings by offsetting income taxed at higher
marginal tax rates. Additionally, the RA of 1978 increase
in the net capital gain deduction reduced the investor's tax
liability in the year of sale. Since the ARR does not
consider the time value of money, these larger (but
deferred) tax savings are assumed to be equivalent to the

early year tax savings.

Tax Rate Impact

 

The use of actual results versus the use of the initial
projections revealed a significant difference in all of the
measures of return when the other variables were collapsed
over the three levels of the tax rate variable. These

measures are reflected in Table 2.

108

Table 2. Summary of Impact by Marginal Tax Rate
Pre-TRA of 1976 Section 8 Housing

 

 

 

 

Structure
Without Tax Reforms With Tax Reforms
Percent Percent Percent
Original Change Change Change
Return Projected Actual From Actual From From
Measure Results Results Column 1 Results Column 1 Column 2
(l) (2) I (3) (4) I (5) I (6)
g;
50% 1.100 0.960 -12.73* 0.898 -18.36* -6.46*
60% 1.268 1.080 -14.83* 1.020 -19.56* -5.56*
70% 1.422 10172 -17658* 1.169 -17079* -0626
ARR
50% 13.126 10.957 -16.52* 10.731 -18.25* -2.06
60% 14.717 11.512 -21.78* 11.338 -22.96* -1.51
70% 15.468 11.335 —26.72* 12.465 -19.41* +9.97*
PB
50% 19.083 45.333 +137.56* 47.670 +149.80* +5.16*
60% 15.833 35.361 +123.34* 42.000 +165.27* +18.77*
70% 13.667 26.417 +93.29* 28.333 +107.31* +7.25*

 

 

 

* Significant at a = .02

Units:

PI-- A PI of one is equivalent to a full recovery of the present
value of the cash investment. A P1 in excess of one is
equivalent to a recovery of more than the present value
of the cash investment.

ARR-~This measure is stated in percentage terms.

PB-- This measure indicates the number of quarters the partner-
ship interest must be held to recover the cash investment.

 

109

A comparison of the actual financial results without
the post-1975 tax reforms and the original projections
revealed that the PI had declined significantly for
investors in the 50, 60, and 70 percent marginal tax
brackets respectively. The ARR also declined significantly
for investors in the 50, 60, and 70 percent marginal
brackets. The PB was likewise affected increasing
significantly for investors in the 50, 60, and 70 percent
marginal brackets. These results, as noted earlier, can be
explained by the smaller than projected losses and the
limited cash return available from these investments.

The use of actual results with the post-1975 reforms
revealed a significant decrease in the PI when compared to
the same results without the reforms for two of the three
levels of marginal tax rates. The PI decreased
significantly for investors in the 50 and 60 percent
marginal tax brackets. However, the change in return for an
investor in the 70 percent marginal bracket was
insignificant. A comparison of the actual results with the
post-1975 tax reforms and the original projections revealed
that the PI declined significantly ataall levels of the tax
rate variable.

Utilizing the actual results with the post-1975 tax
reforms revealed a significant decrease in the ARR when
compared to the same results without the reforms for one of
the three levels of this variable. The increase of 9.97

percent for investors in the 70 percent marginal bracket

110

indicates that some investors may actually perceive a
benefit from the post-1975 tax law reforms (assuming they
utilize the ARR measure). A comparison of the actual
results with the post-1975 tax reforms and the original
projections revealed that the ARR declined significantly at
all levels of the tax rate variable.

The use of actual results with the post-1975 tax
reforms revealed a significant increase in the PB at all
levels of the variable when compared to the same results
without the reforms. A comparison of the actual results
with the post-1975 tax reforms and the original projections
revealed that the PB also increased significantly at all
levels of the tax rate variable.

Once again the results, averaged over the levels of the
marginal tax rate variable, indicate that the initial
projections do not present a reasonable representation of
the return an investor may anticipate. The rent increases
authorized by HUD and the limited cash return available play
a large part in this result. When the actual financial
results were utilized, both with and without the post-1975
tax reforms, the PI for al 1 but the 70 percent marginal
investor was significantly affected. This result is
consistent with the fact that these investors were the only
variable level to consistently utilize the prior maximum tax
on PSI. Thus much of their tax saving was at a fifty
percent marginal rate prior to the tax rate reduction (to a

maximum marginal rate of fifty percent) made by the ERTA of

111

1981. The reduction in the net capital gain tax rate from a
maximum 49 (considering the potential effects of the minimum
and maximum tax as they existed at that time) to 28 and
finally to 20 percent also had its most significant impact
at this level.

The significant increase in the ARR for the 70 percent
marginal investor with the post-1975 tax reforms (when
comparing actual results) is, as explained above, due to
increased nominal tax savings as a result of the even
distribution of tax losses over the years. This nominal tax
savings and the decrease in the net capital gain tax
significantly increased the ARR at this level as the tax
savings for each year are equally weighted. The smaller,
but beneficial, net capital gain rate reduction for the 50
and 60 percent investor profiles kept these levels from

producing significant negative results.

Percentage pf PSI Impact

 

 

The use of actual results versus the use of the initial
projections revealed a significant difference in all of the
measures of return when the other variables were collapsed
over the three levels of the PSI variable. These results
are reflected in Table 3.

A comparison of the actual results without the post-
1975 tax reforms and the original projections revealed that
the PI had declined significantly for investors with PSI as

a percentage of taxable income of 20, 50 and 90 percent

112

 

 

 

 

 

 

 

Table 3. Summary of Percentage of P31 Impact
Pre-TRA of 1976 Section 8 Housing
Structure
Without Tax Reforms With Tax Reforms
Percent Percent Percent
Original Change Change Change
Return Projected Actual Prom Actual From_ From
Measure Results Results Column 1 Results Column 1 Column 2
(1) (2) | (3) (4) I (5) | (6)
§_I
20% 1.309 1.115 -14.82* 1.035 -20.93* -9.99*
50% 1.275 1.073 -15.84* 1.056 -17.18* -1.58
90% 1.206 1.024 -15.09* 0.996 -17.41* -2.73
ARR
20% 15.301 11.918 -22.11* 11.440 -25.23* -4.01
50% 14.655 11.265 -23.13* 11.774 —19.66* +4.52
90% 13.356 10.621 -20.48* 11.320 -15.24* +6.58
PB
26% 15.583 32.333 +107.49* 37.861 +142.96* +17.1o*
50% 15.833 35.833 +126.32* 39.583 +150.00* +10.46*
90% 17.167 38.944 +126.85* 42.556 +147.89* +9.27*
* Significant at 0 = .02

Units:

PI-- A PI of one is equivalent to a full recovery of the present
value of the cash investment. A PI in excess of one is
equivalent to a recovery of more than the present value
of the cash investment.

ARR--This measure is stated in percentage terms.

PB-- This measure indicates the number of quarters the partner-
ship interest must be held to recover the cash investment.

 

 

113

respectively. The ARR also declined significantly at all
levels. The PB was likewise affected increasing
significantly at.all levels. The smaller than projected
losses and the limited nature of the investor‘s cash return
account for these results.

The use of actual results with the post-1975 tax
reforms revealed a significant decrease in the PI for only
one of the three levels of PSI when compared to the actual
results without these reforms. Investors with PSI equal to
just 20 percent of their taxable income had a 9.99 percent
decrease in this measure of return. The most significant
factor in this decline is the fact that they benefited least
from the pre-ERTA maximum tax due to small amounts of PSI.
The repeal of the maximum tax in 1982 reduced their tax
savings from partnership losses from approximately 70
percent of the loss to a maximum of 50 percent. A
comparison of the actual results with the post-1975 tax
reforms and the original projections indicates that the PI
declined significantly at.all levels of the PSI variable.

Utilizing the actual results with the post-1975 tax
reforms revealed no significant changes in the ARR when
compared to the same results without the reforms for any of
the three levels of this variable. A comparison of the
actual results with the post-1975 tax reforms and the
original projections indicates that the ARR declined

significantly at‘all levels of the PSI variable.

114

The use of actual results with the post-1975 tax
reforms revealed a significant increase in the PB for two of
the three levels of this variable when compared to the same
results without the reforms. The PB increased 17.1 percent
for investors at the 20 percent PSI level and 9.27 percent
for those at the 90 percent level. A comparison of the
actual results with the post-1975 tax reforms and the
original projections revealed that the PB increased
significantly atlall levels of the PSI variable.

These results, averaged over the levels of the PSI
variable, indicate that the initial financial projections do
not present a reasonable representation of the return an
investor may anticipate. The smaller than projected losses
and the limited cash return available lead to this result.
The actual results, presented in Table 3, indicate that
(both with and without the post-1975 tax law reforms) only
the PI for the 20 percent investor was significantly
reduced. This result, as noted above, is consistent with
the fact that these investors were the only variable level
unable to utilize the prior maximum tax on PSI. Thus, their
tax saving from investment losses was reduced from a level
of up to 70 percent of the loss to a maximum 50 percent by
the ERTA.Of 1981.

Similar reasoning applies to the insignificant decrease
(4.01 percent) in the ARR for the 20 percent PSI investor.
Despite the decrease in the net capital gains tax in the

year of sale, important in a measure that does not consider

115

the time value of money, the reduction in the marginal rate
of tax savings is sufficient to produce a reduction in the
ARR (although it is insignificant). The increase in the ARR
for the two remaining levels of this variable, although not
significant, reflects the influence of both the net capital
gains tax reduction and the fact that most of these
investors saw no post—ERTA of 1981 reduction in their
marginal tax rates due to the previous availability of the

maximum tax on PSI.

Minimum Tax Impact

 

The use of actual results versus the use of the initial
projections revealed a significant difference in all of the
measures of return when the other variables were collapsed
over the two levels of the minimum tax variable. These
results are presented in Table 4.

A comparison of the actual results without the post-
1975 tax reforms and the original projections revealed that
the PI had declined significantly for investor profiles with
and without a forced minimum tax. The ARR also reflected
significant declines at both levels. The PB produced
similar results, increasing significantly for investor
profiles with and without a forced minimum tax. These
results are once again attributable to the smaller than
projected losses and the limited cash return available from

these investments.

116

Table 4. Summary of Minimum Tax Impact
Pre-TRA of 1976 Section 8 Housing

 

Structure
Without Tax Reforms With Tax Reforms
Percent Percent Percent
Original Change Change Change
Return Projected Actual From Actual From From
Measure Results Results Column 1 Results Column 1 Column 2
(1) (2) I (3) (4) I (5) I (6)
21
Not
Forced 1.317 1.128 -14.35* 1.066 -19.06* -5.50*
Forced 1.210 1.013 -l6.28* 0.992 -18.02* -2.07
ARR
Not
Forced 13.239 10.427 -21.24* 11.118 -16.02* +6.63
PB
Not
Forced 15.444 30.500 +97.49* 35.963 +132.86* +17.91*
Forced 16.944 40.907 +141.42* 42.704 +152.02* +4.39

 

 

 

 

 

 

* Significant at 9 = .02

Units:

PI-- A PI of one is equivalent to a ful 1 recovery of the present
value of the cash investment. A P1 in excess of one is
equivalent to a recovery of more than the present value
of the cash investment.

ARR--This measure is stated in percentage terms.

PB-- This measure indicates the number of quarters the partner-
ship interest must be held to recover the cash investment.

 

 

117

The use of actual results with the post-1975 tax
reforms revealed a significant decrease in the PI when
compared to the same results without the reforms for one of
the two levels of the minimum tax variable. The PI
decreased 5.5 percent for investors not subject to the
forced minimum tax. The P1 was reduced for those investor
profiles subject to the forced minimum tax, but not
significantly. This suggests that the decrease in the
minimum tax preference exemption (thereby increasing the
number of periods investors without the forced minimum tax
were subject to the tax) was more significant than the
increase in the tax rate from 10 to 15 percent. A
comparison of the actual results with post-1975 tax reforms
and the original projections revealed that the PI declined
significantly at all levels of the minimum tax variable.

The use of actual results with the post-1975 tax
reforms did not reveal a significant change in the ARR when
compared to the same results without the tax reforms. This
indicates that, if time value considerations are ignored,
the reduced tax on net capital gains offsets the larger
amounts of minimum tax paid in the early years of the
investment. A comparison of the actual results with the
post-1975 tax reforms and the original projections revealed
that the ARR declined significantly at both levels of the
minimum tax variable.

The use of actual results with the post-1975 tax

reforms revealed a significant increase in the PB for one of

118

the two levels of the minimum tax variable when compared to
the same results without the reforms. The PB increased
17.91 percent for investor profiles that were not subject to
the forced minimum tax. The absence of a significant
increase in the PB for investor profiles with a forced
minimum tax once again indicates that the increase in the
tax rate, from 10 to 15 percent, did not significantly
affect investor returns. A comparison of the actual results
with the post-1975 tax reforms and the original projections
revealed that the PB increased significantly at both levels
of the minimum tax variable.

These results, averaged over the levels of the minimum
tax variable, indicate that the initial projections do not
present a reasonable representation of the return an
investor may anticipate. The smaller than projected losses
and the limited cash return are primarily responsible for
this result. When the actual results were utilized, both
with and without the post-1975 tax reforms, only the PI
without the forced minimum tax and the PB without the forced
minimum tax were significantly affected. This points to the
significant effect produced by increasing the number of
periods that investors were subject to the add-on minimum
tax through a reduction in the preference exemption. The
increase in the tax rate alone did not significantly affect
investor returns. The mixed results for the ARR with and

without a forced minimum tax also reflects the impact of a

119

decrease in the net capital gains tax rate when the time

value of money is not a factor.

Selling Price Impact

The use of actual results versus the use of the initial
projections revealed a significant difference in all of the
measures of return when the other variables were collapsed
over the three levels of the selling price variable. These
measures are reflected in Table 5.

A comparison of the actual results without the post-
1975 tax reforms and the original projections revealed that
the PI declined significantly for those investor profiles
with selling prices equal to their mortgage balance, a
compounded three percent annual appreciation in value, and
the original cost respectively. The ARR also declined
significantly atlall levels of this variable. The
percentage increase in the PB was the same over all levels
of this variable. This result is attributed to the fact
that a sale occurs in the final quarter of the holding
period. If payback was not achieved prior to this point in
time (the last quarter), the ultimate selling price had no
effect on the number of quarters necessary to recover the
investment. Once again, the overall explanation for these
significant results is smaller than projected losses and the
limited cash return available from these investments.

The use of actual results with the post-1975 tax

reforms revealed a significant reduction in the PI when

Table 5. Summary of Impact by Selling Price
Pre-TRA of 1976 Section 8 Housing

 

 

Structure
Without Tax Reforms With Tax Reforms
Percent Percent Percent
Original Change Change Change
Return Projected Actual From Actual From From
Measure Results Results Column 1 Results Column 1 Column 2
(1) (2) I <3) (4) I (5) | (6)
£1
Mortgage
Balance 1.191 0.983 -17.51* 0.926 -22.25* —5.75*
3% Appre-
ciation 1.364 1.191 -12.68* 1.177 -13.71* -1.18
Original
Cost 1.235 1.037 -16.03* 0.983 -20.40* -5.21*
ARR
Mortgage
Balance 10.258 6.953 -32.22* 6.438 -37.24* -7.41*
3% Appre-
ciation 20.293 17.252 -14.99* 18.848 -7.12* +9.25*
Original
Cost 12.761 9.598 -24.79* 9.248 -27.53* -3.65
PB
Mortgage .
Balance 16.194 35.704 +120.48* 39.333 +142.89* +10.16*
3% Appre-
ciation 16.194 35.704 +120.48* 39.333 +142.89* +10.16*
Original
Cost 16.194 35.704 +120.48* 39.333 +142.89* +10.16*

 

 

 

 

 

 

* Significant at a c .02

Units:
PI-- A PI of one is equivalent to a ful 1 recovery of the present
value of the cash investment.
ARR--This measure is stated in percentage terms.
PB-- This measure indicates the number of quarters the partner-
ship interest must be held to recover the cash investment.

 

 

121
compared to the same results without the reforms for a
selling price equal to the mortgage balance (5.75 percent)
and for a sale at original cost (5.21 percent). This
reduction is attributable to the previously noted changes in
the minimum tax and the reduction in the highest marginal
tax brackets both of which reduced the tax savings from
these investments. The reduction in the net capital gain
tax rate and the removal of the capital gain deduction from
the list of preferences subject to the add-on minimum tax
actually mitigated the decrease (an insignificant change in
the PI) for that selling price which benefitted most from
these changes--the appreciated selling price which produced
the largest net capital gain. A comparison of the actual
results with the post-1975 tax reforms and the original
projections revealed that the PI declined significantly at
all levels of the selling price variable.

Utilizing the actual results with the post-1975 tax
reforms revealed a significant change in the ARR when
compared to the same results without the reforms for two of
the three levels of this variable. A selling price equal to
the mortgage balance at the time of sale resulted in a 7.41
percent decrease in the ARR. Because a sale at this price
would yield the smallest possible net capital gain (among
the levels of the variable utilized), the decrease in the
net capital gains tax rate had little effect on this level

of the variable. Therefore, the larger number of periods

122

the investor profiles were subject to the revised add-on
minimum tax significantly reduced the ARR.

A selling price equal to three percent annually
compounded appreciation to the date of sale resulted in a
9.25 percent increase in the ARR. Because a sale at this
price would yield the largest possible net capital gain
(among the levels of the variable utilized), the decrease in
the net capital gains tax rate was sufficient to completely
offset the minimum tax changes. Hence, this investor
profile is shown to benefit from the post—1975 tax reforms
(if the ARR is utilized).

A comparison of the actual results with the post-1975
tax reforms and the original projections revealed that the
ARR declined significantly at all levels of the selling
price variable. The use of actual results with the post-
1975 tax reforms also revealed a significant increase in the
PB at all levels of this variable when compared to the same
results without the reforms. A comparison of the actual
results with the post-1975 tax reforms and the original
projections revealed that the PB increased significantly at
all levels. Thus the ultimate selling price was not a
factor in determining the PB.

Once again the results, averaged over the levels of the
selling price variable, indicate that the initial financial
projections do not present a reasonable representation of
the return an investor may anticipate. When the actual

results were utilized, with and without the post-1975 tax

123

reforms, the PI for all but the appreciated selling price
was significantly affected. This indicates that, at this
level of the variable, time value considerations and the
larger amount of minimum tax to be paid were almost entirely
offset by the decrease in the net capital gains tax rate. A
similar result was obtained for the ARR when the original
cost of the project was utilized as the selling price. This
selling price produced a net capital gain that fell between
that for the other two levels of this variable, causing both
significant negative and positive results at those levels.
Thus, the insignificant change in the ARR is attributable to
the decline in the net capital gain tax rate which offset

the post-1975 minimum tax changes.

Holding Period Impact.

 

The use of actual results versus the use of the initial
projections revealed a significant difference in all of the
measures of return when the other variables were collapsed
over the three levels of the holding period variable. These
results are presented in Table 6.

A comparison of the financial results without the post-
1975 tax reforms and the original projections revealed that
the PI had declined significantly for holding periods of I
nine, 12, and 15 years respectively. The ARR also declined
significantly at all levels of this variable. The PB was
likewise affected increasing significantly at all levels.

This result is attributable to the smaller than projected

124

Table 6. Summary of Impact by Holding Period
Pre-TRA of 1976 Section 8 Housing

 

 

Structure
Without Tax Reforms With Tax Reforms
Percent Percent Percent
Original Change Change Change
Return Projected Actual From Actual From From
Measure Results Results Column 1 Results Column 1 Column 2
(l) (2) I (3) (4) I (5) I (6)
3;
Nine
Years 1.193 1.072 -10.14* 1.017 -14.75* -5.13*
Twelve
Years 1.277 1.075 ~15.82* 1.036 ~18.87* -3.63*
Fifteen
Years 1.321 1.064 ~19.45* 1.034 ~21.73* ~2.82
ARR
Nine
Years 16.106 12.964 -19.51* 12.323 -23.49* -4.94
Twelve
Years 14.337 11.065 -22.82* 11.335 -20.94* +2.44
Fifteen
Years 12.869 9.775 -24.04* 10.876 -15.49* +11.26*
PB
Nine
Years 16.190 30.550 +88.70* 32.890 +103.15* +7.66*
Twelve
Years 16.190 35.770 +120.94* 39.550 +144.29* +10.57*
Fifteen
Years 16.190 40.770 +151.82* 45.550 +181.35* +11.72*

 

 

 

 

 

 

* Significant at a = .02

Units:
PI-- A PI of one is equivalent to a ful 1 recovery of the present
value of the cash investment.
ARR--This measure is stated in percentage terms.
PB-- This measure indicates the number of quarters the partner-
ship interest must be held to recover the cash investment.

 

 

125
losses and the limited cash return available from these
investments.

The use of actual results with the post-1975 tax
reforms produced a significant reduction in the PI when
compared to the same results without the reforms for both
the nine and 12 year holding periods. This result is
attributable to the increase in the number of periods
investors were subject to the minimum tax and to the
increase in the recapture potential due to the adoption of
the 200 month rule (a holding period related change). A
comparison of the actual results with the post-1975 tax
reforms and the original projections revealed what the PI
declined significantly at.all levels of the holding period
variable.

Utilizing the actual results with the post-1975 tax
reforms produced a significant increase in the ARR when
compared to the same results without the reforms for one of
the three levels of this variable. The 15 year holding
period produced an 11.26 percent increase in the ARR. This
result reflects the negligible amount of excess depreciation
to be recaptured after 15 years (under the 200 month rule)
and the significance of the decrease in the net capital
gains tax rate. A comparison of the actual results with the
post-1975 tax reforms and the original projections revealed
that the ARR declined significantly at all levels of the

holding period variable.

126

The use of actual results with the post-1975 tax
reforms also revealed a significant increase in the PB at
all levels of this variable when compared to the same
results without the reforms. A comparison of the actual
results with the post-1975 tax reforms and the original
projections revealed that the PB increased significantly at
all levels.

Once again the results, averaged over the three levels
of the holding period variable, indicate that the initial
projections do not present a reasonable representation of
the return an investor may anticipate. When the actual
financial results were utilized, with and without the post-
1975 tax reforms, the PI for all but the 15 year holding
period was significantly affected. This indicates that when
the time value of money is considered, the decrease in the
net capital gains tax rate is more than offset by the
increase in the number of periods the investor profiles were
subject to the minimum tax and by the larger amount of the
gain recaptured as ordinary income. However, because there
is virtually no excess depreciation to recapture after a 15
year holding period, the reduction in the PI (due to this
provision) is negligible and the percentage change at this
level is insignificant.

The shorter holding periods produce a significant amount
of depreciation to be recaptured as ordinary income. When
the time value concept is ignored (as in the ARR), the

decrease in the net capital gain tax rate becomes more

127

significant. Thus the reduced capital gains tax almost
exactly offsets the increased depreciation recapture and
minimum tax at the nine and 12 year holding periods
(producing insignificant changes). When the recapture
potential is eliminated, after a 15 year holding period, the
capital gain reduction is sufficient to produce a

significant increase in the ARR.

The Effect of the ERTA of 1981 and
Relevant Legislation Variables

The model described in Chapter IV was utilized to
evaluate the impact of the ERTA of 1981 and relevant tax
provisions applicable to government-assisted low-income
housing. For each of the 12 actual 1980-81 projects
evaluated, 486 different parameter combinations were
produced bylallowing each of the following four variables to
assume various levels: marginal tax.rate (3 levels),
investment holding period (3 levels), selling price of the
project (3 levels), and the add-on minimum tax (2 levels).
Additionally, the projections were reformulated as though
the partnerships began operations in 1982 (one of the major
reformulations being the use of the ACRS lS-year life for
real property to conform to the ERTA of 1981). Each
reformulated projection was further modified by: (1)
revising the projections to capitalize and amortize
construction period interest and taxes, (2) revising the

projections to reflect 175 DB cost recovery (from the 200 DB

128

availableeonly for low-income housing), (3) revising the
projections to incorporate 100 percent recapture of excess
cost recovery deductions (from the phase-out under the 200
month rule available only for low-income housing), and (4)
combining the above revisions so that the four possible
interactions could be examined.

The following return measures were produced for each
parameter set: profitability index (PI) based on a 20
percent discount rate, undiscounted average rate of return
(ARR), and the payback (PB). These return measures were
then averaged across the variables under study such as the
marginal tax rate, investment holding period, sales price
and cost recovery method utilized. The results provide the
basis for the following discussion which addresses two
objectives of this study:

1. To determine the impact of the ERTA of 1981 on
expected returns for an investment in low-income
housing.

2. To investigate the differential impact of the
tax provisions specifically enacted to provide
an incentive for investment in low-income
housing.

The research results demonstrating the effects of the
ERTA of 1981 and other selected legislation variables are
presented below in three sections: (1) the effect on the
payback (PB), (2) the effect on the average rate of return

(ARR), and (3) the effect on the profitability index (PI).

129

Payback Results

A comparison of the original 1980-81 projections and
the reformulated projections (to conform to the ERTA of
1981) produced only two significant changes in the PB as
shown in Table 7. When the results were averaged over the
taxable income variable, the PB rose from 21.92 and 18.17 to
22.58 and 19.17 quarters for investors in the pre-1982 60
and 70 percent marginal tax brackets respectively. This
longer PB suggests that the larger loss available to the
investors, as a result of increased cost recovery
deductions, is less significant than the ERTA of 1981
reduction in the maximum marginal tax rate to 50 percent
(which reduced the tax savings from the losses). It also
suggests that while most investor profiles formerly subject
to the 60 and 70 percent marginal tax rates could utilize
the pre-1982 maximum tax on PSI, the reduction in income
eligible for this provision (due to the preferences created
by these investments) resulted in significant amounts of
income being taxed at rates above 50 percent.

Despite the above changes, no significant difference
arose when the returns were averaged over the following
variables: holding period, selling price, the add-on minimum
tax, and the overall combination of the above variables.
This suggests that the changes made by the ERTA of 1981 had
their most significant impact on investors that, prior to

1982, were in marginal tax brackets exceeding 50 percent.

130

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131
However, when averaged over all of the nonlegislation
variables, the results show that the changes made by the
ERTA of 1981 did not significantly affect the PB for
investors in Section 8 housing.

A further reformulation of the 1980-81 projections, to
reduce the method of cost recovery to a 175 DB rate over 15
years, produced a significant increase in the PB at all
levels of the nonlegislation variables. The overall
increase was from 23.69 to 25.43 quarters. Averaging the
returns over the selling price variable produced the same
increase for each of the three levels of this variable.
This is a significant increase in the PB but the level of
this variable is not a factor in determining its size. This
result is attributable to the selling price, which is
received at the end of the investment holding period and is
not a factor in determining the PB.

Averaging the returns over the taxable income variable
produced a significant increase at all levels for investors
in the pre-1982 50, 60 and 70 percent marginal tax rates
respectively. The PB for the minimum tax variable also
increased significantly for investors with and without a
forced minimum tax. These results indicate that the ACRS
recovery schedule for low-income housing (200 DB) and other
forms of real property (175 DB) has a significant effect on
the PB. The increase was fairly stable over a1 1 of the
variables. The major exception to this stability, the

taxable income variable, indicates that the pre-1982 70

132
percent investor profile was affected more by this change
than the 50 percent profile.

A revision of the depreciation recapture percentage for
low-income housing-~moving away from the 200 month rule to
one that recaptures all excess depreciation without
reference to a holding period--produced no changes in the
PB. This is consistent with the fact that depreciation
recapture occurs when the property is sold and has no effect
on the PB.

The final legislation variable to be examined
independently was the capitalization and amortization of
construction period interest and taxes. Since the effect of
this revision is to defer deductible amounts until later
years, this reformulation was expected to increase the PB.
Averaging over all of the nonlegislation variables produced
a significant increase in the PB atlall levels of the
nonlegislation variables. Tfimzoverall increase over these
variables was from 23.69 to 26.5 quarters.

The increase averaged over the holding period variable
was significant at all levels. Averaging the returns over
the selling price variable produced an increase from 23.69
to 26.5 quarters at all levels of this variable. This
result is consistent with the fact that the ultimate selling
price has no effect on the PB. .Averaging the returns over
the taxable income and minimum tax variables also produced a
significant increase at all levels. These results clearly

indicate that forcing low-income housing to capitalize and

133
amortize construction period interest and taxes would
significantly increase the PB. The major deviation from the
11 to 12 percent average increase was the taxable income
variable. Once again this change would have a larger impact
on investors with larger amounts of taxable income.

In both instances where the interaction of the
potential change in depreciation recapture was combined with
either the 175 DB cost recovery or the capitalization of
construction period interest and taxes variables, the
results were unaffected by the change in the method of
recapture (iJL, columns four and 10 and columns eight and
12 are equal). This result is consistent with recapture
(coming at the time of sale) having no effect on the PB.

The remaining dual interaction, 175 DB cost recovery
and the capitalization and amortization of construction
period interest and taxes, produced a significant increase
lJlthE PB at‘all levels of the nonlegislation variables.

The overall increase was from 23.69 to 27.38 quarters.

The increase, when averaged over the holding period
variable, was significant at all levels. Once again the
increase associated with the selling price variable was not
affected by the level of that variable. The increase was
from 23.69 to 27.38 quarters for each of the three levels of
this variable. Averaging the returns over the taxable
income and the minimum tax variables also produced
significant increases at all levels. This dual interaction

produced the most significant increase in the PB. Once

134
again, this change has the largest impact on the return of
investors with higher levels of taxable income.

The final interaction examined was a combination of all
three legislation variables. Here the projections were
reformulated to reflect 175 DB cost recovery, the
capitalization and amortization of construction period
interest and taxes, and excess cost recovery recapture that
was not a function of the holding period of the property.
Because these results are exactly the same as those for the
dual interaction of 175 DB cost recovery and construction
period interest and taxes (discussed above), they are
consistent with a finding that the method of depreciation
recapture was not a factor in determining the PB.

Overall, the results indicate that two of the three
provisions enacted to aid low-income housing and examined in
this study have a significant effect on the PB. The
availability of 200 DB cost recovery and the provision
exempting low-income housing from the capitalization and
amortization of construction period interest and taxes have
the effect of reducing the PB by an average of 15.58

percent.

Average Rate pf Return (ARR) Results

A comparison of the 1980-81 projections and the
reformulated projections (to conform to the ERTA of 1981)
produced only one significant change in the ARR. These

results are presented in Table 8.

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136

When the results were averaged over the selling price
variable, the ARR rose from 17.44 to 18.31 percent for a
selling price equal to three percent annually compounded
appreciation. Because this selling price is the highest
level of this variable, it also produced the largest gain on
sale (some of which would be treated as ordinary income but
the majority of which would be a potential net capital
gain). This result indicates that the reduction in the net
capital gain tax (to a maximum 20 percent) and the maximum
marginal tax rate became significant when the sale of the
investment produced a large net capital gain.

No significant difference arose when the returns were
averaged over the following variables: holding period,
taxable income, the add-on minimum tax, and the overall
combination of the above variables. This result is
attributable to the nature of the ARR measure. Because it
does not consider the time value of money, the reduced early
year tax savings (due to the lower marginal tax rates) are
offset by a reduced tax liability at the time of sale. This
result is also reflected in the selling price variable where
the only reduction in the ARR (although insignificant)
occurs when the results are averaged over that level
producing the smallest gain on sale. This indicates that
the reductions in the marginal tax rates produced almost no
change in the ARR while the reduction in the net capital
gain tax produced a generally positive (but insignificant)

increase.

137

A further reformulation of the 1980-81 projections, to
reduce the method of cost recovery to a 175 DB rate over 15
years, produced no significant difference in the ARR when
the results were compared to the initial reformulations.
Despite the lack of significant results, averaging over the
nonlegislation variables produced a small increase in the
ARR in every instance. This result is attributable to the
smaller excess cost recovery preference (thereby reducing
the minimum tax liability) and the reduction in the amount
of excess cost recovery to be recaptured as ordinary income
on sale.

A revision of the recapture percentage for low-income
housing, moving away from the 200 month rule to one that
recaptures all excess depreciation without reference to a
holding period, produced no significant changes in the ARR.
Although not significant, all of the results indicate a
slight reduction in the ARR. This small reduction indicates
that low-income housing benefits marginally from the 200
month rule.

The final legislation variable to be examined
independently was the capitalization and amortization of
construction period interest and taxes. It also produced no
significant reduction in the ARR. Therefore, amending the
tax law to require the capitalization and amortization of
construction period interest and taxes, as is currently
required for other real property, would have only a marginal

impact on an investor‘s ARR.

138

The dual interaction of reducing the cost recovery rate
to 175 DB and changing the depreciation recapture variable,
as described above, produced no significant changes in the
ARR when the results were compared to the initial
reformulations. This coincides with the individual results
for these variables. When examined independently one
variable, 175 DB cost recovery, produced slightly positive
results while the recapture variable produced slightly
negative results. The results for this interaction fall
between those for the two variables examined independently.

The interaction of a change in the method of
depreciation recapture and in the treatment of construction
period interest and taxes, produced a significant reduction
in the ARR at.all levels of the selling price variable when
the results were compared to the initial reformulations. A
selling price equal to the mortgage balance was significant
at the two percent confidence level and the two remaining
levels were significant at a ten percent confidence level.
This result follows from a reduction in tax savings due to a
decrease in the size of the net capital gain. The reduction
in the size of the net capital gain, due to the change in
the depreciation recapture rules, arose because a larger
share of the excess cost recovery deductions are subject to
recapture as ordinary income. However, the rationale is
more subtle for construction period interest and taxes.
When these costs are capitalized and amortized at a rate of

10 percent for each year of operation, they are not always

139

fully amortized when the property is sold. When this
occurs, the basis for the property at the date of sale is
relatively large and this produces a lower gain on sale.
Because the gain is smaller, the amount of net capital gain
is also reduced.

The remaining dual interaction, 175 DB cost recovery
and the capitalization and amortization of construction
period interest and taxes, produced no significant
difference in the ARR when the results were compared to the
initial reformulations. This is consistent with the
individual results for these variables. When examined
independently, one variable, 175 DB cost recovery, produced
slightly positive results while the construction period
interest and taxes variable produced slightly negative
results. The interaction results fall between those for
each of the variables examined independently.

The interaction of all three legislation variables
produced no significant differences in the ARR when the
results were compared to the initial reformulations. This
is consistent with the individual results for these
variables. When examined independently, one of the three
variables produced a slight increase in the ARR while the
other two produced slight decreases when the results were
compared to the initial reformulations. Once again, the
interaction falls between the largest and the smallest

changes produced by the variables independently.

140
Profitability Index (PI) Results

A comparison of the 1980-81 projections and the
reformulated projections (to conform to the ERTA of 1981)
produced one significant difference in the PI at a two
percent confidence level and an additional six significant
differences at the 10 percent confidence level. These
results are presented in Table 9.

When the results were averaged over all of the
nonlegislation variables, the PI declined from 1.09 to 1.06.
This indicates that the changes made by the ERTA of 1981
(increased cost recovery deductions and a reduction in the
maximum marginal tax rate) have a significant effect on the
return available to Section 8 investors when the time value
of the tax savings is considered.

Among the three levels of the holding period variable,
only the 15 year holding period produced a significant
decline with the PI falling from 1.14 to 1.11. This
reflects the declining value of the reduced net capital gain
tax as the time period lengthens and the reduced tax savings
in later years, when the ACRS deduction is smaller than that
available under pre-ERTA law.

Averaging the results over the three levels of the
selling price variable produced significant reductions at
two levels of this variable--a sale at the mortgage balance
and at original cost. This reflects the fact that there is
little or no net capital gain produced at these selling

prices. Therefore, the reduction in the net capital gain

141

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142

tax rate has almost no effect. The reduced marginal tax
rates decreased the tax savings from the investment losses
more than the tax savings added by the increased early year
deductions (due to the ACRS).

When the PI is averaged over the three levels of the
taxable income variable, two of the three levels produced
significant decreases. The P1 was reduced for an investor
in the pre-l982 70 percent marginal tax bracket and to a
lesser extent for an investor in the pre-1982 60 percent
marginal tax bracket. The reduced PI indicates that the
larger early year losses, available to the investors as a
result of increased cost recovery deductions, are less
significant than the ERTA of 1981 reduction in the maximum
marginal tax rate to 50 percent (which reduced all post-1981
tax savings from the losses). It also indicates that while
most investor profiles (formerly subject to the 60 and 70
percent marginal brackets) were able to utilize the pre-1982
maximum tax rate on PSI, the preference offset resulted in
significant amounts of pre-1982 income being taxed at rates
above 50 percent.

Of the two levels for the add-on minimum tax, the level
that did not force the tax produced a significant decline
from 1.11 to 1.08. This occurs because many investors, not
previously subject to the tax (or paying a smaller minimum
tax), were subject to the minimum tax on a more frequent
basis and in larger amounts. This arises because of smaller

regular tax payments due to the tax decreases made by the

143

ERTA of 1981 and the larger cost recovery deductions
available under the ACRS which produce larger amounts of
excess cost recovery preferences in the early years. This
larger preference base, offset by a smaller amount of
regular tax, produced more frequent and larger minimum tax
consequences to investors.

A further reformulation of the 1980-81 projections, to
reduce the method of cost recovery to a 175 DB rate over 15
years, produced a significant decrease in the PI for all but
one level of the nonlegislation variables when the results
were compared to the initial reformulations. The overall
decline was from 1.06 to 1.03. This decrease indicates that
the special provision granting low-income housing 200 DB
cost recovery (versus 175 DB for other residential housing)
is significant when the time value of the tax savings is
considered.

When the results were averaged over the holding period
variable, significant decreases were noted for each of the
three levels. When the P1 was averaged over the selling
price variable a significant decrease was also noted at
every level. Averaging the PI results over the taxable
income variable produced significant decreases for investors
with the largest amounts of taxable income. For investors
that prior to 1982 would have been in the 60 and '70 percent
marginal tax brackets, the decrease was from 1.07 and 1.19
to 1.04 and 1.14 respectively. This indicates that

investors with larger amounts of taxable income would be

144

significantly affected by a reduction in the cost recovery
method to 175 DB. The minimum tax variable was not a
significant factor in the overall PI decrease. Whether the
add-on minimum tax was forced or the investor incurred it as
a result of other preferences, the PI declined by
approximately the same magnitude.

These results indicate that the ACRS recovery schedule
for low-income housing (200 DB) and for other forms of real
property (175 DB) produces a significant differential when
the time value of the tax savings is incorporated into the
return measure. However, the PI for investors whose early
year losses produce tax savings at a rate below the 50
percent maximum marginal rate was not significantly
affected.

A revision of the depreciation recapture percentage for
low-income housing, changing from the 200 month rule to one
that recaptures all excess depreciation without reference to
a holding period, produced no significant reductions in the
PI for low-income housing. This result is consistent with
the fact that recapture does not occur until the year of
sale and, because it is on a discounted basis, has little
effect on investor returns.

The final legislation.variable to be examined
independently was the capitalization and amortization of
construction period interest and taxes. Since the effect of
this reformulation is to defer deductible amounts until

later years, the PI is significantly reduced at-all levels

145

of each of the variables when the results are compared to
the initial reformulations. The overall reduction was from
1.06 to .95 and represents the most significant single
legislation variable in reducing the PI.

The decrease when averaged over the holding period,
selling price, taxable income, and minimum tax variables was
significant at every level. These results indicate that if
construction period interest and taxes were to be
capitalized and amortized on low-income housing projects,
their PI would be significantly affected. This decrease was
a fairly stable 10 to 11 percent when averaged over the
nonlegislation‘variables.

The dual interaction of decreasing the cost recovery
rate to 175 DE and revising the method of depreciation
recapture, as discussed above, produced 11 significant
decreases in the PI when the results were compared to the
initial reformulations. The overall decrease was from 1.06
tx>lu03. Averaging the results over the three levels of the
holding period variable produced significant results at the
two percent confidence level for the 12 and 15 year holding
periods. The decline in the PI at the nine year level was
significant at the 10 percent confidence level. These
results are almost entirely attributable to the reduced
level of cost recovery deductions.

When the results were averaged over the selling price
variable, two levels produced significant reductions in the

PI at the two percent confidence level. The decline in the

146

PI at the original cost level was significant at the 10
percent confidence level. Once again these results are
almost entirely attributable to the reduced level of cost
recovery. Significant reductions also occurred in the
taxable income variable at the pre-l982 60 and 70 percent
levels (from 1.07 and 1.19 to 1.04 and 1.14 respectively)
and in the minimum tax variable at both levels. The
reductions, once again, are almost entirely attributable to
the reduced method of cost recovery. The absence of a
significant reduction for the 50 percent level indicates
that investors with lower levels of taxable income are the
only investor profiles that would not be significantly
affected by decreasing the method of cost recovery.

The dual interaction of capitalizing and amortizing
construction period interest and taxes and revising the
method of depreciation recapture, as discussed above,
produced significant decreases in the PI at‘all levels of
the nonlegislation variables when the results were compared
to the initial reformulations. The overall decrease was
from 1.06 to .95. The decrease when averaged over the
holding period, selling price, taxable income, and minimum
tax variables was significant at every level. These
reductions are almost entirely attributable to the
capitalization and amortization of construction period
interest and taxes, and are a fairly stable 10 to 12 percent

over all levels of the nonlegislation variables.

147

The dual interaction of decreasing the cost recovery
rate to 175 DE coupled with the capitalization and
amortization of construction period interest and taxes
produced significant decreases in the PI atmall levels of
the nonlegislation variables when the results were compared
to the initial reformulations. The overall decrease was
from 1.06 to .94. The decrease when averaged over the
holding period, selling price, taxable income, and minimum
tax variables was also significant at every level. This
interaction represents the most significant reduction in the
PI due to an interaction of two legislation variables and is
a fairly stable 11 to 12 percent over the nonlegislation
variables.

Finally, the interaction of all three legislation
variables reduced the PI significantly atlall levels of the
nonlegislation variables when the results were compared to
the initial reformulations. The overall decrease was from
1.06 to .93.

The interaction of the three legislation variables
produced the overall lowest.PI for every level of each of
the variables. This indicates that legislation adopted to
favor low-income housing is consistent with congressional
intent. The existence of the three legislation variables
examined in this study provides low-income housing with an
increased return when the time value of the tax savings is a

factor in measuring investor returns.

148

Summary

The primary objective of this study was to determine
the impact of the TRA of 1976, the RA of 1978, and the ERTA
of 1981 on the profitability of investments in Section 8
housing. Two computer models were utilized in this
analysis. The models allowed for an evaluation of the
investments over time periods and across variables such as
the investor's marginal tax rate, the investment selling
price, and various holding periods.

Additional research questions examined in this study
included an examination of the impact of: (1) allowing low-
income housing to utilize 200 DB cost recovery while
limiting other forms of real estate investments to 175 DB,
(2) allowing a phase-out of the Sec. 1250 recapture
percentage for low-income housing (200 month rule) while
requiring 100 percent recapture of excess cost recovery
deductions for other forms of residential real estate, and
(3) allowing low-income housing to deduct, on a current
basis, construction period interest and taxes while
requiring other forms of real estate to capitalize and
amortize those costs.

In general, the results of this study indicate the
importance of considering tax factors in making Section 8
investment decisions. The findings also indicate that the
impact of the tax laws, and the resulting investment return,

may be substantially altered by the investor‘s marginal tax

149

rate, investment holding period, and the ultimate sales
price of the investment.

Specifically, the study revealed that the investment
prospectuses utilized in this study significantly overstated
the tax benefits available to the investors even with an
analysis which assumed that the pre-TRA of 1976 tax law
remained in effect over the entire holding period. The TRA
of 1976, the RA of 1978, and the ERTA of 1981 were also
shown to have had a significant negative impact on
investments in Section 8 housing which preceeded all three
Acts.

While the ERTA of 1981 significantly increased the cost
recovery deductions for Section 8 housing and reduced the
net capital gain tax to a maximum 20 percent, a present
value analysis indicates that the reduction in the maximum
marginal tax rate to 50 percent and the increase in the
level at which income is subject to those rates produced a
negative impact on investor returns in Section 8 housing.
Alternativelyy the provisions specifically enacted to favor
low-income housing were shown to increase the investment

return.

Investment Prospectuses

The most common advice given an investor contemplating
an investment in a syndicated partnership is to obtain the
prospectus and proceed to determine the tax benefits, tax

detriments, and cash flows for the investment. In so doing

150
the tax and business assumptions expressed in the prospectus
are accepted as reliable and accurate.

As the results of this study demonstrate, the
projections made in the prospectus do not represent an
accurate picture of the eventual tax consequences. In every
instance the tax benefits were overstated, thus leading
investors to anticipate larger investment returns than those
actually obtainable. This was shown to be the result
despite the removal of the tax risk inherent in these
investments. It should be noted that the tax risk in this
instance is the risk that Congress wil l amend the tax law so
as to materially alter an investor's return. As noted
below, this risk is very real.

Two of the major risks impacting upon the investments
in this study were the economic risk and the risk
surrounding government regulation of rents and
distributions. The economic risk with the largest impact on
Section 8 housing over the 1975-1982 period was inflation.
The average increase in rents over this period exceeded the
increase in the cash expenses of these investments and
significantly reduced the tax losses available to the
investors. As previously discussed, these pass-through
losses represent the bulk of an investor‘s return. Because
HUD regulations severely limit the cash distributions from
these partnerships, the cash dividends paid to the investors
were unable to offset the reduced tax savings from the

smaller losses. This resulted in significantly smaller

151
investment returns than those anticipated by the original

projections.

Impact of Tax Changes on Existing Investments

The federal tax structure is a major tool of fiscal
policy. As such, this structure is often employed to assist
certain segments of the national economy. Tax shelters
often arise from the provisions enacted to assist these
segments. However, the intended assist may be subverted if
investors anticipate future tax changes which would reduce,
or otherwise limit, the benefits of an existing investment.
The results of this study conclusively demonstrate that, for
Section 8 investments, Congress has retroactively reduced
the return of investments made prior to the enactment of the
TRA of 1976.

While many of the changes made by the TRA of 1976, the
RA of 1978, and the ERTA of 1981 affect only shelters
organized on or after their effective dates, the following
changes made by these Acts affected existing Section 8
investments (as previously described):

1. Changes in depreciation recapture

2. Changes in the minimum tax on preference items

3. Changes in the maximum marginal tax rates

4. Changes in the effective tax rate on net

capital gains
5. Changes in the maximum tax on personal service

income (and its eventual elimination)

152

While investors are unlikely to quarrel with Congress
over reductions in the marginal and net capital gain tax
rates, they may actually reduce a tax shelter investorks
return. However, this reduction is offset by the tax saving
on other forms of income. The more controversial provisions
involve the changes in the minimum tax and in the
depreciation recapture provisions. These changes reduced an
investor‘s return on existing investments and provided no
compensating tax reductions on other income. This adds an
unnecessary element of risk to the investment process which
may subvert the assistance contemplated when Congress
adOpted or enlarged a tax expenditure. The risk could be
mitigated if investors were assured that future tax law
changes would be effective only for investments entered into

after the date of enactment.

Impact of ERTA on Section g Investments

 

In 1981, Congress concluded that a program of
significant multi-year tax reductions was needed to
stimulate future economic growth. These tax reductions were
intended to assist in upgrading the nationfs industrial
base, stimulating productivity and innovation throughout the
economy, reducing personal tax burdens, and restraining the
growth of the federal government. This led to the tax
reductions enacted by the ERTA of 1981.

Other provisions of the ERTA of 1981 represent a

radical break with the past. The concept of "useful life"

153
is no longer relevant in determining the return on capital
invested in depreciable property. The focus has been
reoriented from depreciation of the physical property to
recovery of the capital expended. The relevant factor has
changed from a focus on the "useful life" of the asset to
the apprOpriate period for recovery of the capital expended
to acquire the asset.

The overall rate reduction and the adoption of the
ACRS, as noted above, had the largest impact on Section 8
investment of the numerous provisions incorporated into the
ERTA of 1981. The immediate result of the cut in the
maximum marginal tax rates was to make investment losses
less attractive since the after-tax cost, for many
investors, increased from 30 to 50 percent. This caused
many investment advisors to proclaim the end of the tax
shelter era.

However, the capital recovery provisions of the ERTA of
1981 had the effect of increasing the early year deductions
(thereby increasing the pass-through loss) for these
investments. It also increased the excess accelerated cost
recovery which was subject to both the minimum tax and to
potential recapture when the prOperty was sold. Because
Section 8 housing relies upon a significant portion of an
investor‘s return being derived from pass-through
deductions, additional depreciation in the early tax years
provides an added incentive for this type of investment.

This study examined the way in which these conflicting

154
provisions (reduced marginal tax rates and larger capital
recovery deductions) affected a Section 8 investor‘s return.

A review of the results indicates that the decrease in
the marginal tax rates, the increase in the minimum tax
preference item due to larger recovery deductions, and the
increase in the cost recovery recapture potential more than
offset the larger early year deductions made available by
the adoption of 15-year 200 DB cost recovery for low—income
housing. Thus the overal 1 effect of the ERTA of 1981 was to
decrease the returns available to investors in Section 8
housing relative to the return available under prior law.
This result should not be construed as concluding that a
Section 8 investment is more or less attractive (relative to
alternative forms of investment) as a result of the ERTA of
1981. The relative attractiveness of Section 8 housing as
an investment is beyond the scope of this study.

Another result of the ERTA of 1981 changes was an
increase in the complexity of the tax law. This makes the
evaluation of the incentives to invest in low-income housing
a complicated process and must surely reduce the

effectiveness of the contemplated incentive.

Provisions to Encourage Investment in Low-income Housing
Three provisions intended to provide additional tax
incentives to invest in low-income housing were examined in
this study. The general rationale provided for these
incentives is the governmental restrictions placed on low-

income housing and, all tax consequences being equal, the

155

preconception that investors would rather invest in shopping
centers or other commercial projects.

This study clearly indicates that if the construction
period interest and taxes, cost recovery rate, and recapture
provisions applicable to residential housing were to apply
to low-income housing, investor returns would be reduced
significantly. The most beneficial provision is that
exempting low-income housing from the requirement to
capitalize and amortize construction period interest and
taxes, followed by the larger cost recovery deductions
allowable to low-income housing, with the recapture
differential adding marginally to the increased return.

It should be noted, however, that this study does not
suggest that returns from low-income housing exceed those
from other forms of real property. Governmental
restrictions, the limited appreciation potential, and the
maintenance costs of low-income housing may far exceed the
tax advantages. However, this study does conclude that
these provisions, in varying degrees, provide a tax

incentive to invest in low-income housing.

Conclusion
Portions of Chapters I and II dealt with Congressional
rationale for the tax changes introduced by the Acts
examined in this study. Individually, each change logically
supports the objective cited for that change. Collectively,

however, the legislation has resulted in numerous complex

156

modifications which are inconsistent with any single set of
goals. Congress significantly reduced the return available
from a low-income housing investment when it passed the TRA
of 1976, the RA of 1978, and the ERTA of 1981.

While these reforms may be consistent with the
objective of equity in the tax law, they are inconsistent
with U.S. public policy as reflected in the Housing and
Urban Development Act of 1968 and reaffirmed in 1974 by the
addition of Section 8 to the United States Housing Act of
1937. That Act sought to encourage and support the
construction, by the private sector, of multifamily housing
for low-income families as well as the elderly and
handicapped. Tax benefits were considered an essential
ingredient in the production of this housing as recognized
by the TRA of 1969.

The production of such housing rests upon the ability
of the housing industry to obtain major capital backing.
The nature of this industry requires the commitment of huge
sums of capital over long periods of time. A portion of
this capital comes from HUD-insured loans, from bonds issued
by State housing finance agencies and from conventional
mortgages. In the final analysis, however, somewhere
between 10 and 20 percent of every project must be financed
by private equity investors.

While much of the rationale for the changes indicate a
desire to favor low-income housing, the complexity of the

current law suggests that those incentives may be difficult

157

to properly evaluate. Of primary importance is the general
rule that investors should analyze potential investments on
a case-by-case basis utilizing a comprehensive tax analysis.
Federal tax statutes have become more complex as a result of
the Acts examined by this study. The use of simplistic
rules of thumb or computations employing only an investor‘s
marginal tax rate are likely to yield misleading results.
Perhaps the most striking implication of this study is
that the ability of our tax system to satisfy the varied
demands which are placed upon it diminishes as the number
and diversity of those demands are increased. Every change
that complicates the tax law threatens those provisions
intended to assist certain segments of our economy.
Whatever advantages are derived from the use of tax
policy to achieve economic and social objectives, there are
important disadvantages. Tax preferences contract the tax
base, requiring higher tax rates on income not subject to
preferential treatment. This leads to the further use of
tax preferences as those taxpayers subject to high marginal
tax rates seek to reduce their tax burden. When this
occurs, demands arise for tax reform to eliminate the tax
avoidance measures fostered by the higher rates on income
not subject to preferential treatment. For example, low-
income housing investments that shelter nonrealty income are
pOpular among taxpayers subject to high marginal tax rates,
but they create the perception that these individuals are

avoiding their tax responsibilities. The result is an

158

erosion in the public confidence that the tax system is
equitable.

Tax preferences also tend to be difficult to eliminate.
Priorities change and goals originally pursued are no longer
sought but the preference continues. This may be attributed
to the fact that the preference becomes a part of the
property‘s value and eliminating it induces losses for those
who purchased the assets at values that reflected the tax

benefit.

B IBLIOGRAPHY

B I BL I OGRAPHY

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Brookings Institution, 1972.

Aronsohn, Alan J. B., ”The Real Estate Industry‘s Position
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Bleck, Erich K" ”Real Estate Investments and Rates of
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pp. 535-547.

 

Brueggeman, William B. and Jeffrey D. Fisher, "How the New
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Review, 7 (Fall, 1977), pp. 65-71.

 

Cleveland, Grover A”.“The Impact of the Tax Reform Act of
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Dorr, Patrick B., "The Impact of the Tax Reform Act of 1976
and Other Proposed Legislation on Investment in Real
Estate Tax Shelters" (Unpublished.I&nD. Dissertation,
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Hemmer, Edgar Hu.”How a Computer Thinks About Real Estate”,
Real Estate Review, 4 (Winter, 1975), pp. 113-123.

HUD, Housing in the 70's, Washington, U. 8. Government
Printing Office, 1974.

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51 (December, 1973), pp. 770-812.

Krane, Howard G., WEconomic Analysis of Tax Sheltered
Investments", Taxes, 54 (December, 1976), pp. 806-831.

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159

160

Lane, Bruce 8., ”The Tax Reform Act of 1976: What it means
for Real Estate Limited Partnerships" , Journal of Real
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Mayer, Martin, The Builders, New York, W. W. Norton & Co.,
Inc., 1978.

 

McKee, William S" “The Real Estate Tax Shelter: A
Computerized Expose", Virginia Law Review, 57

Messner, Stephen D. and M. Chapman Findlay, III, “Real
Estate Investment Analysis: IRR Versus FMRRP, The Real
Estate Appraiser, 41 (July-August, 1975), pp. 5- 20.

 

Miles, Mike, "Impact of the 1976 Tax Reform Act: A Real
Property Tax Planner‘s Review", The Appraisal Journal,
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Pyhrr, Stephen A”.”A Computer Simulation Model to Measure
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Ritter, C. Willis and Emil M. Sunley, Jr., "Real Estate and
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Shillingburg, J. Edward, "Winding Up Real Estate Tax
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Stern, Jerrold J3, ”Tax Legislation of 1976 and 1978: An
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161

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Whitmire, Robert L. and Kerry M. Reynolds, "Selecting the
Optimum Depreciation Method for Real Estate Under the
New ACR System", The Journal pf Taxation, 55 (December,
1981), pp. 360-363.

 

Willis, Arthur B.,2Partnership Taxation, Vols. 1 and 2, New
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Wyndelts, Robert‘W”,"Tax Planning and an Analysis of
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