The Tax Shelter from Hell – U.S. Steel Tower in Pittsburgh

Investing in a partnership that owned an iconic building in Pittsburgh –The U.S Steel Tower  – has turned into a tax nightmare for out of state investors.  When people invested in real estate shelters in the early to mid 1980s, they usually did not give a lot of thought to state income taxes. In many states, it would be safe to assume that the state income income taxes would tag along with the federal income taxes – benefits in the early years and costs in the later years after the dreaded crossover with perhaps a large cost on disposition of the property.  No thought was given to the implications of the underlying real estate being in a different state than the investor.

The partners in 600 Grant Street Limited Partnership are finding this lack of forethought rather expensive.  Among them is Robert Marshall who does not live in Pennsylvania.  He recently received bad news from the Commonwealth Court of Pennsylvania.   The Court told him that although the computations need a bit of fine tuning, the position of the Commonwealth’s Department of Revenue is essentially correct.

 Mr. Marshall put about $150,000 into the partnership and received a little more than $6,000 in distributions over the roughly 20 years that he owned an interest in the partnership. The real estate was sold at a sheriff’s sale in 2005 without generating any net proceeds for the limited partners.  In 2008, Revenue (as the Court refers to the department) informed Mr. Marshall that he owed Pennsylvania $165,055.24 for 2005.  I think his reaction may have been something to the effect of that does not even make good nonsense.  Over 20 years on net he lost over $140,000 in Pennsylvania.  For that the state thinks he owes them in income tax somewhat more than he lost.  To understand how that might be you need to know just a bit about old fashioned real estate shelters.

When you buy a piece of real estate by taking out a mortgage, it is almost certain that your taxable income from the property will be different from your cash flow.  Principal amortization on the mortgage requires cash but does not produce a deduction.  Depreciation, on the other hand, is deductible, but does not require a cash outlay.  So a building that is breaking even on cash flow after debt service will produce a taxable loss if the depreciation is greater than the principal amortization on the mortgage.

Buildings placed in service between 1981 and 1986 could be depreciated over less than 20 years.  So in the early years at break-even cash flow, there would be losses.  Eventually you “cross over” and the mortgage principal payments would exceed the depreciaion giving you “phantom income”.  On top of that, your basis in the building would be less than your mortgage balance, which some people refer to as negative basis.There was generally the assumption that the building will have appreciated, since everybody knew that real estate only went up.  On top of that even if you had to walk away from the building and recognize phantom income on the disposition, the gain would be a capital gain.  Since your losses would have sheltered income subject to a 50% tax rate, you would still be ahead.  That is if you put your tax savings in excess of your investment into tax exempt bonds.  There must have been somebody somewhere who actually did that.  He probably flossed regularly too.

That was the basic engine that made things work.  There were a lot of bells and whistles available.  One of them, which Mr. Marshall seems to have taken advantage of is an extended pay in period of about seven years for his investment.  A well structured shelter would give you 2 for 1.  That is the losses for a year would be twice your payment for that year.  With a 50% rate, it was like you were getting the investment for free.  The other technique, which was a little less common, was that the 14.55% purchase money mortgage did not have to have all the interest paid if there was not enough cash flow.  So not only were you getting depreciation deductions you were getting negative principal amortization.  This was the feature that would bite the out of state investors in an uncomfortable place.  In 2005, at the sheriff’s sale the original $308 millon dollar purchase money mortgage had grown to 2.6 billion.

Mr. Marshall went into this deal in January 1985.  Little did he suspect that he was at the end of the era.  The Tax Reform Act of 1986 changed the landscape.  No more short lives for real estate.  A lower top marginal rate.  The Passive Activity Loss rules which would cause most of his losses to be suspended unless he had other passive income.  I’m not an economist but I believe that the Act reduced the value of commercial real estate by removing its inherent tax shelter characteristics.

It turns out that the “sherriff’s sale” transaction generated a little bit of publicity in 2005.  According to this story the foreclosure was a friendly transaction.  A new entity, 600 GS Prop LP, controlled by the same group (but likely not the same limited partners), had acquired the mortgage.  By structuring the transfer as they did, the avoided substantial transfer taxes, but also may have created interest on the part of the Department of Revenue.   They were not troubled by the possiblity that someone would come to the sale and bid 2.6 billion. (The Tower has 2.3 million square feet.  I don’t think that you are going to see values in excess of $1,000 per square foot in Pittsburgh any time soon.) One wonders if the departing limited partners were cautioned about their potential liability to Pennsylvania.

It is What It is – Deal With It

Mr. Marshall received a K-1 showing losses every year for 20 years. Since he apparently had no other income from Pennsylvania he did not need to file a return there.  If he did not have other passive income those losses would have been suspended after the first few years of transition into the new regime of the Internal Revenue Code of 1986.  So when the phantom income hit all at once in 2005 there may have been substantial losses released.  Conceivably because the phantom income was capital gain, Mr. Marshall would have actually come out ahead in 2005.  Since Mr. Marshall did not get anything in 2005, why is there a gain ?  The balance of a non-recourse mortgage is deemed to be proceeds in the sale of a property.  So for the tax purposes of the partners in 600 Grant Limited Parntership, it is as if somebody did bid 2.6 billion for the property.

The rather lengthy decision gets into the 2.6 billion being deemed proceeds.  It then discusses how things are different in Pennsylvania.  Pennsylvania does not suspend losses. So even if Mr. Marshall had been filing every year in Pennsylvania he would not have a store of losses to use in the big income year.  It is even worse though.  Pennsylvania does not have a very high rate – 3.07%, but it only wants to be partners with you when you are winning.  Even if the whole 21 years of activity were stuffed into 2005, Mr. Marshall would have the same problem.  The interest deduction that built up the 2.6 billion dollar debt and the depreciation deductions that reduced the basis in the building created rental losses.  The gain on the sale of the building is a different class of income under Pennsylvania law.  When you compute your total taxable income in Pennsylvania you take each of the classes and add the ones that are are positive.  You do not subtract the ones that are negative.

Mr. Marshall threw out several arguments all of which were knocked by the Court.  There was one, however, that I think deserved more scrutiny:

Since the partnership interest is an intangible asset, gain or loss on its dispostion will not enter into the computation of a non-resident tax.  There are two interesting things about this.  One is whether Mr. Marshall had an unused escape hatch from this nightmare.  If he had abandoned the interest before the foreclosure would he have escaped the Pennsylvania tax ? More to the point, though, is the question of how the Pennsylvania partners had a loss on the partnership liquidation.  Did Revenue allocate the foreclosure gain on a straight percentage basis rather than using substantial economic effect principles ?  If the limited partners were getting no money, their share of the gain allocation should have brought them to 0, not to a positive basis in their partnership interests.  Given all the other defenses that were thrown up, it is hard to believe that this one was overlooked, but I really wish I had a chance to study the K-1′s.

The state taxable income in most states tracks federal taxable income pretty closely.  That is not true in all states.  Pennsylvania appears to be one of the more peculiar states in this regard.  I’d be very cautious about highly leveraged real estate deals in Pennsylvania.

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