When That Tax Shelter Comes Home to Roost

It is important to know the tax attributes of assets to be divided in a divorce. One such asset that deserves special consideration is the old-fashioned “tax-shelter”. In many cases, the interest may be more of a hot potato than a valuable asset to be coveted.

The classic tax-shelter investment is a limited partnership interest in a real estate venture. It was organized by a promoter or syndicator who often managed the properties. The investment was usually highly leveraged using mortgages on the underlying property. The investor would invest a small amount of cash in proportion to the debt. Because of the leverage, the investor would receive deductions far in excess of his or her cash investment during the first few years of the venture.

The difference between the amount of cash invested and the losses utilized by the investor will be recognized as gain on the ultimate disposition of the underlying property. Because there are often no corresponding funds distributed to the investor associated with this inherent gain, it is known as “phantom income”. There are many tax-shelter partnerships floating around with large amounts of “phantom income” associated with them. Many of them are close to insolvency and will eventually be subject to foreclosure, at which time the phantom income will be triggered to the investors.

The income and losses generated from most tax shelter partnerships are known as “passive” income or losses. Passive losses can only reduce passive income. Passive losses that are greater than passive income in any one year must be suspended and carried forward to the next tax year. The suspended passive losses may only be utilized when the individual either has more passive income than losses or finally disposes of the tax shelter investment in a taxable event (not a divorce).

Husbands and wives who file joint returns must separately keep track of their suspended passive losses from the tax shelter investments they own. Upon a divorce, each spouse retains the separate passive losses as well as the potential gain associated with the tax shelters they owned prior to the divorce. If one spouse obtains a tax shelter that was formerly owned by the other spouse, the rules are different. The gain or phantom income associated with the investment transfers to the transferee spouse. Any suspended passive loss disappears, but the amount of such suspended loss increases the basis to the transferee.

The following examples illustrate these rules:

Example 1: H owns tax shelter A and H and W jointly own tax shelter B. Tax shelter A has a potential gain of $20,000 and a $10,000 suspended passive loss. Tax shelter B has a potential gain of $10,000 and a $5,000 suspended passive loss. Upon divorce, H receives tax shelter A and each spouse receives a one-half interest in tax shelter B. H has potential gain of $25,000 ($20,000 from A and $5,000 from B) and suspended passive losses of $12,500 ($10,000 from A and $2,500 from B). W has potential gain of $5,000 and passive losses of $2,500 from tax shelter B.

Example 2: Same as example 1 except H transfers tax shelter A to W. H has potential gain of $5,000 and passive losses of $2,500 from tax shelter B. Wife has the same $5,000 potential gain and $2,500 passive loss from B. From tax shelter A, W has no passive loss but a $10,000 potential gain ($20,000 potential gain less the $10,000 suspended loss).

Unless the tax shelter partnership interests can generate more cash than the large tax burdens that they carry (which is quite unusual), neither spouse will want to receive these “assets.” It’s important to make sure that the client does not get burned by the hot potato.