Series 7 Unit 11

The exam will probably give more attention to the following disadvantages:

-Liquidity Risk: greatest disadvantage for a DPP investor is lack of liquidity b/c the secondary market for DPPs is limited, investors who want to sell their interests frequently cannot locate buyers. -Legislative Risk. When Congress changes tax laws, new rules can cause substantial damage to LPs, who may be locked into illiquid investments that lose previously assumed tax advantages. -Leverage Risk. It is common for DPPs to use borrowed funds. Although the leverage can boost returns, it can have the same effect on losses. The risk is even higher when partnership uses recourse debt. -Risk of audit. Statistics from the IRS indicate that reporting ownership of a DPP results in a significantly higher percentage of returns selected for audit. -Depreciation recapture. One of the tax benefits is the ability to depreciate most fixed assets, especially when that depreciation can be accelerated. The effect of the depreciation deduction is to lower the tax basis of the asset. If that asset is then sold for more than that basis, the excess is recaptured and is subject to tax, possibly at ordinary income tax rates.

Real Estate Investment Trust (REIT)

A company that manages a portfolio of real estate investments to earn profits and or income for its shareholders. Professional management and diversification. Normally publicly traded and serve as a source of long-term financing for real estate projects. A REIT pools capital in a manner similar to an investment company. 3 basis types of REITs: Equity REITS Mortgage REITS Hybrid REITS

DPP Roll-UP

A roll-up is a transaction involving the combination or reorganization of one or more limited partnerships into securities of a successor corporation. The lure to investors is the possibility of turning an illiquid DPP into a more liquid security. Disclosure documents prepared in connection with a proposed roll-up transaction must -disclose all the risk factors -disclose the GP's belief concerning fairness of the transaction -include all reports, opinions, and appraisals received by the GP in connection with the transaction Failure to provide adequate disclosure of a negative opinion rendered by an investment banker or financial adviser concerning fairness constitutes FRAUD. Under FINRA rules, members are prohibited from soliciting votes from LPs in connection with a proposed roll-up unless any compensation to be received by the member -is payable and equal in amount regardless of whether the LPs vote affirmatively or negatively, and -does not exceed 2% of the value of the securities to be received in the exchange

If an investor expects to have a large amount of passive income over the next two years, which of the following programs listed will most likely lead to the largest amount of shelter?

A) Real estate income B) Equipment leasing C) Oil and gas drilling D) Undeveloped land purchasing Answer is C E: Passive income can only be sheltered by passive loss, so the real estate income program will only add to the income. Oil and gas drilling programs allocate the majority of investment dollars to drilling. These are intangible drilling costs (IDCs), which are 100% deductible when drilling occurs. Undeveloped land has very little in the way of losses, and equipment leasing programs usually generate income shortly after starting.

Subscription Agreement

All investors interested in becoming LPs (passive investors) must complete a subscription agreement. The agreement appoints one or more GPs to act on behalf of the investors and is only effective when the GPs sign it. Along with the subscriber's money, the subscription agreement must include -the investor's net worth -the investor's annual income -a statement attesting that the investor understands the risk involved -a power of attorney appointing the GP as the agent of the partnership. In addition to a cash contribution, subscribers may assume responsibility for the repayment of a portion of a loan made to the partnership. This type of loan is called a RECOURSE LOAN. Frequently, partnerships also borrow money through nonrecourse loans; the GPs have responsibility for repayment of nonrecourse loans. (Not the LPs) TTA** LPs are liable for a proportionate share of recourse loans assumed by partnerships. LPs have no liability for nonrecourse loans and only in real estate DPPs does the nonrecourse loan add to the investor's basis.

Tax Basis

An investor's tax basis represents the upper limit on deductibility of losses. LPs must keep track of their tax basis, or amoubt at risk, to determine their gain or loss upon the sale of their partnership interest. An investor's basis is subject to adjustment periodically for occurrences such as cash distributions and additional investments. A LPs basis consists of: -cash contributions to the partnership -noncash property contributions to the partnership -recourse debt of the partnership -nonrecourse debt for real estate partnerships only Partners must adjust their basis at year-end. Any distributions of cash or property and repayments of recourse debt (also nonrecourse debt for real estate only) are reductions to a partner's basis. Partners are allowed deductions up to the amount of their adjusted cost basis. Example: if a partner's basis is $25,000 at year end and the investor has losses of $35,000, only $25,000 of the losses may be used to deduct against passive income. The remaining $10,000 may be carried forward.

Structuring of Limited Partnership

An unincorporated organization with two or more members is generally classified as a partnership for federal tax purposes if its members engage in a trade, business, financial operation, or venture and divide its profits. In the case of a limited partnership, one of the members is the limited partner (LP) and the other is the general partner (GP). An organization is classified as a partnership for federal tax purposes if it has two or more members and is none of the following: -An organization that refers to itself as incorporated or as a corporaion -An insurance company -A REIT -An organization classified as a trust or otherwise subject to special treatment under the IRC. To qualify as a partnership, the business entity must avoid corporate characteristics such as continuity of life. This is the easiest of the corporate characteristics to avoid b/c partnerships have a predetermined date of dissolution when they are established, whereas corporations exist in perpetuity.

Programs allowing for the direct pass-through of losses and income to investors include all of the following except A) real estate investment trusts (REITs). B) S corporations. C) oil and gas drilling direct participation programs. D) new-construction real estate direct participation programs.

Answer is A E: REITs allow for the direct pass-through of income, but not losses. The other choices are forms of business that allow for pass-through of income and losses.

An investor acquires limited partner status in a direct participation program when A) he and the general partner have both signed the subscription agreement. B) the certificate of limited partnership is filed in its home state. C) his money is received by the general partner. D) he submits a signed copy of the subscription agreement.

Answer is A E: The investor must sign a copy of the subscription agreement, but he is not considered a limited partner until the agreement is also signed by the general partner indicating acceptance of the limited partner.

A tool used by investment banking firms to combine several unsuccessful limited partnership programs into one new entity is A) a DPP rescue. B) a merger. C) a DPP rollup. D) a multiprogram partnership.

Answer is C E: A DPP rollup is a transaction involving the combination or reorganization of one or more limited partnerships into securities of a successor entity. In general, this involves DPPs that have not been successful. The attraction to investors is the possibility of turning an illiquid DPP into a security with greater liquidity.

An investor in an oil and gas limited partnership program is subject to the economic consequences of all of the following except A) depreciation on tangible assets. B) recourse loans. C) operating losses. D) nonrecourse loans.

Answer is D E: Nonrecourse loans only have economic consequences for investors in real estate programs.

FINRA RULE 2310

Before participating in a DPP offering, member firms must have reasonable grounds for believing, based on the information provided in the prospectus, that all material facts are adequately disclosed and that these facts provide a framework for customers to evaluate the program.

LPs Prohibited Activities

CANNOT Act on behalf of the partnership or participate in its management Knowingly sign a certificate containing false information Have their names appear as part of the partnership's name

GPs Prohibited Activites

CANNOT: Compete against the partnership for personal gain. Borrow from the partnership Commingle partnership funds with personal assets or assets of other partnerships Admit new GPs or LPs or continue the partnership after the loss of a GP unless specified in the partnership agreement.

Cash Flow

Cash flow is defined as net income or loss plus noncash changes (such as depreciation) EXAMPLE: Revenue: $300,000 Less costs: Selling $50,000 Interest $70,000 Operating $160,000 Depreciation $50,000 totals $330,000 Net Loss ($30,000) This example shows a loss of $30,000. However, when we add back in depreciation, the cash flow is a positive $20,000 net income or loss ($30,000) + depreciation $50,000 cash flow +$20,000

Developmental

DEVELOPMENTAL Partnership Objective: Drill near existing fields to discover new reserves (called step-out wells) Advantages: less discovery risk than exploratory Disadvantages: few new wells produce Tax Features: medium intangible drilling costs, immediate tax sheltering Degree of Risk: medium to high risk

Issuing Partnership Investments

DPPs may be offered either as private placements, qualifying for an exemption from registration under state and federal low, or publicly registered either with the SEC, the state(s) or both. Most are sold in private placements. When sold privately, usually limited to only accredited investors. Sales are conditioned upon acceptance of subscribers. That means that just b/c the investor wants to buy, he many not be accepted by the GP. Many offerings, use wholesalers. These are individuals or firms paid to serve as an interface between the issuer and broker-dealers and their sales force. It is legal for them to be compensated for their services. That compensation is usually on the basis of sales program interests. One of the most important requirements is performing DUE DILIGENCE. FINRA defines that as "the exercise of reasonable care to determine that the offering disclosures are accurate and complete." This helps the BD avoid fraud charges. Investigating the background of the management is one action taken in performing due diligence. For those who have a track record, checking it is an important step. Finally, the BD will evaluate all fees and other distribution of the offering's proceeds.

DPPs

Direct Participation Programs are investments that pass income, gains, losses and tax benefits (such as depreciation, depletion, and tax credits) directly to the limited partners. There are some unique tax concepts and suitability issues associated with DPPs. Limited Partnerships are one of the most common types of DPPs. They can be set up as an S corporation or limited liability companies (LLC).

Real Estate Partnerships: Existing Property

EXISTING PROPERTY Partnership Objective: Generate an income stream from existing structures Advantages: Immediate cash flow, known history of income and expenses Disadvantages: greater maintenance or repair expenses than for new construction; expiring leases that may not be renewed; less than favorable rental arrangements Tax Features: deductions for mortgage interest and depreciation Degree of Risk: relatively low risk

Exploratory (Wildcatting)

EXPLORATORY (WILDCATTING) Partnership Objective: locate undiscovered reserves of oil and or gas Advantages: high rewards for discovery of new resources Disadvantages: few new wells produce Tax Features: high intangible drilling costs for immediate tax sheltering Degree of Risk: HIGH, ***most risky oil and gas program

Partnership Agreement

Each partner receives a copy of this agreement. It describes the roles of the GPs and LPs and guidelines for the partnership's operation.

Equipment Leasing Programs

Equipment leasing programs are created when DPPs purchase equipment leased to other businesses. Investors receive income from lease payments and also a proportional share of write-offs from operating expenses, interest expenses, and depreciation. Tax credits were once available but have been discontinued. **The primary investment objective of these programs is tax-sheltered income.**

Business Deductions

Expenses of the partnership, such as salaries, interest payments, and management fees, result in deductions in the current year to the income of the business. Principal payments on property are not deductible expenses. Cost recovery systems offer write-offs over a period of years as defined by the IRS schedules. DEPRECIATION WRITE-OFFS apply to cost recovery expenditures for equipment and real estate (land cannot be depreciated). DEPLETION ALLOWANCES apply to using up of natural resources such as oil and gas. Depreciation and depletion allowances may be claimed only when income is being produced by the partnership. Also, recognize that some assets are not depreciable, nor can they be depleted. For example, farm crops fall into this category and are generally known to be renewable assets. **Depreciation may be taken on a straight-line or accelerated basis. Accelerated depreciation, known as a modified cost recovery system, increases deductions during the early years and decreases them during the later years. The CROSS OVER POINT is the point at which the program begins to generate taxable income instead of losses. This generally occurs in the later years when income increases and deductions decrease.

FINRA Rules Dealing with DPPs

FINRA Rule 2310 is specifically titled Direct Partnership Programs. Many of the requirements placed upon member firms and their representatives have been included where relevant in this unit.

Certificate of Limited Partnership

For legal recognition, the certificate of LP must be filed in the home state of the partnership. It includes -The partnership's name -The partnership's business -The principal place of business -The amount of time the partnership expects to be in business -The conditions under which the partnership will be dissolved -The size of each LPs current and future expected investments -The contribution return date -The share of profits or other compensation to each LP -The conditions for LP's assignment of ownership interests -Whether the LP may admit other LPs -Whether the business can be continued by remaining GPs at death or incapacity of a GP.

Real Estate Partnerships: Government-Assisted Housing Programs

GOVERNMENT-ASSISTED HOUSING PROGRAMS Partnership Objective: develop low-income and retirement housing Advantages: tax credits and rent subsidies Disadvantages: low appreciation potential; risk of changing government programs; high maintenance costs Tax Features: tax credits and losses Degree of Risk: relatively low risk

Dissolving a Limited Partnership

Generally, Limited partnerships are liquidated on the date specified in the partnership agreement. Early shutdown may occur if the partnership sells or disposes of its assets or if a decision is made to dissolve the partnership by the LPs holding a majority interest. When dissolution occurs, the GP must cancel the certificate of limited partnership and settle accounts in the following order: -Secured Lendors -Other Creditors -LPs -first, for their claims to shares of profits -second, for their claims to a return of contributed capital -GPs -first, for fees and other claims not involving profits -second, for a share of profits -third, for capital return

Real Estate Partnerships: Historic Rehabilitation

HISTORIC REHABILITATION Partnership Objective: develop historic sites for commercial use Advantages: tax credits for preserving historic structure Disadvantages: potential cost overruns; no established track record; difficulty finding permanent financing; inability to deduct current expenses during construction period. Tax Features: tax credit and deductions for expenses and depreciation Degree of Risk: Similar to risk of new construction

GPs

Have unlimited liability: personal liability for all partnership business losses and debts. Management responsibility: assumes responsibility for all aspects of the partnership's operation Fiduciary responsibility: morally and legally bound to use invested capital in the best interest of the investors.

Other Evaluation Factors

Here are additional factors that investors should consider it their overall analysis of these investments: -Management ability and experience of the GP in running other similar programs. -BLIND POOL or nonspecific program --- in a blind pool, less than 75% of the assets are specified as to use: however, in a specified program, at least 75% have been identified. -Time frame of the partnership -Similarity of start-up costs and revenue projections to those of comparable ventures -Lack of liquidity of the interest Partnership interests are not for all Investors. Careful consideration must be given to the overall safety and lack of liquidity of these programs before investing. The DPP Investor enjoys several advantages, including -an investment managed by others -flow through of income and certain expenses -limited liability: the most the investors can lose is the amount of their investment plus any funds committed for, but not yet remitted

Income

INCOME Partnership Objective: provide immediate income from sale of existing oil Advantages: immediate cash flow Disadvantages: oil prices; well stops producing Tax Features: income sheltering from depletion allowances Degree of Risk: low

TTA**

Important Points to remember about REITs -An owner of REITs holds an undivided interest in a pool of real estate investments. -REITs are liquid b/c they trade on exchanges and OTC -REITs are not investment companies -REITs offer dividends and gains to ivnestors but do not offer flow-through losses like LPs, and therefore are not considered DPPs -REITs must distribute 90% or more of income to shareholders to avoid being taxed like a corporation -Dividends from REITs are not qualified, they are taxed as ordinary income.

Risks of owning REITs

Investor has no direct control over the portfolio and relies on professional management to make all purchase and sale decisions. While the expectation of having a professionally managed portfolio should be considered advantageous, the quality of the portfolio lies with the quality of the professional management. REITs generally have greater price volatility than direct ownership of real estate b/c they are influenced by stock market conditions. If the REIT is not publicly traded, liquidity is very limited. As a result, there is the need for more stringent suitability standards and the regulators give greater scrutiny to trades in unlisted REITs. Problem loans in the portfolio could cause income and or capital to decrease.

Evaluating the DPP

Investor should consider the economic viability of the Economic Viability means that there is potential for returns from cash disbursements and capital gains. Although tax benefits may be attractive, they should not be the first consideration in the purchase of an interest in a DPP.

Issuing Limited Partnership Interests

Limited Partnerships may be sold through private placement or public offerings. If sold privately, investors receive a PRIVATE PLACEMENT MEMORANDUM for disclosure. Generally, such private placements involve a small group of investors, each contributing a large sum of money. These investors MUST be ACCREDITED INVESTORS-- that is, they must meet certain net worth or income standards. The general public does not meet this description. In a public offering, partnerships are sold with a prospectus to a larger number of investors, each making a relatively small capital contribution such as $1000 to $5000 dollars. The SYNDICATOR oversees the selling and promotion of the partnership. The syndicator is responsible for the preparation of any paperwork necessary for the registration of the partnership. Syndication or finders fees are limited to 10% of the gross dollar amount of securities sold.

Limited Partners (LPs)

Limited liability: can lose no more than their investment and proportionate interest in recourse notes. No management responsibility: provides capital for the business but may not participate in its management; known as a passive investor. Attempting to take part in a management role jeopardizes limited liability status May sue the GP: lawsuits may recover damages if the GP does not act in the best interest of the investors or uses assets improperly.

Tax Filing Requirements for Limited Partnerships

Limited partnerships do not file a formal tax return b/c everything flows through to the investors. An information return is filed on form 1065, with a Schedule K-1 sent to the partners indicating the amount of income or loss attributable to each of them. The business entity pays no income tax, all reportable income/loss flows through to the partners. Form 1065 is due on March 15 of the following year. The year-end for these businesses is typically Dec. 31st. Taxes are due on April 15, when the individual partners file their FORM 1040 showing their share of the business's income or loss that was reported on the Schedule K-1.

GPs allowed activities

Make decisionss that legally bind the partnership. Buy and sell property for the partnership Maintain a financial interest in the partnership (minimum of 1%) Receive compensation as specified in the partnership agreement.

SEC Rules Dealing with DPPs

Most DPPs are private offerings under Regulation D of the Securities Act of 1933. That will be covered in detail in Unit 20. Generally, purchasers must be accredited investors as defined in SEC Rule 501. DPPs that are offered to the public must meet the SEC's registration requirements.

Real Estate Partnerships: New Construction

NEW CONSTRUCTION Partnership Objective: build new property for potential appreciation Advantages: appreciation potential of the property and structure; minimal maintenance costs in the early years Disadvantages: potential cost overruns; no established track record; difficulty finding permanent financing; inability to deduct current expenses during construction period. Tax Features: depreciation and expense deductions after construction is completed and income is generated Degree of Risk: less risky than new land, more risky than existing property

Oil and Gas Partnerships

Oil and Gas programs include speculative drilling programs and income programs that invest in producing wells. We will list them from most to least risk: Exploratory, developmental, and income

Mortgage REITs

Own Mortgages on commercial property. They make real estate loans (mortgages). Their earnings come from the interest payment on those loans.

Hybrid REITs

Own commercial property and own mortgages on commercial property. A combination of both mortgage and equity REITs

Equity REITs

Own commercial property. They take an ownership position in the properties. They receive rental income and possible capital gains upon a future sale of the properties.

Real Estate Partnerships: Raw Land

RAW LAND Partnership Objective: purchase undeveloped land for its appreciation potential Advantages: appreciation of potential property Disadvantages: offers no income distributions or tax deductions Tax Features: no income or depreciation deductions, not considered a tax shelter Degree of Risk: **Most speculative real estate partnership

Benefits of REITs in a portfolio

REITs allow investors the opportunity to invest in real estate without incurring the degree of liquidity risk historically associated with real estate because REITs trade on exchanges and OTC Properties are selected by professionals with greater negotiating power than an individual. There is a negative correlation to the general stock market b/c real estate prices and the stock market frequently move in the opposite directions There is reasonable income and or potential capital appreciation.

REITS continued

REITs are organized as trusts in which investors buy and sell shares either on stock exchanges or in the OTC market. They are not redeemable as is the case with MFs or UITs, but they have liquidity of listed stocks. REITs do not compute a NAV per unit. The price of the REITs are based on supply and demand and not the estimated NAV of the properties.

REIT Taxation

REITs enjoy a unique hybrid status for federal income tax purposes. A REIT shareholder generally is taxed only on dividends paid by the REIT and on gains upon disposition of REIT shares. A REIT is a corporation for US Tax purposes. The REIT is generally not subject to corporate tax if it distributes to its shareholders substantially all of its taxable income for each year. To avoid being taxed, a REIT must distribute 90% or more of its taxable income and it must receive 75% or more of its income from real estate. Shareholders receive dividends from investment income. These dividends are taxed at ordinary income rates rather than as qualified dividends. If there are capital gains distributions, they are generally taed at long term capital gains rate. A tax related concern for investors is that failure to meet the distribution rules could cause the REIT to be taxed. THat would lead to another level of taxation before the income gets to the investor.

Real Estate Partnerships

Real estate DPPs are by far the most popular type. There are five different kinds, some offer income, some offer potential growth, and some offer both. -Raw Land -New Construction -Existing Property -Government-Assisted Housing Programs -Historic Rehabilitation

Computing Tax Basis

Tax basis is computed using the following fomula: Investment in partnership + Share of recourse Debt (+nonrecourse debt for real estate DPPs) - cash or distributions = cost basis. **Any up-front costs incurred by the investor will not affect beginning basis. Assume that an LP invests $50,000 in a partnership unit, and the BD selling the unit takes a commission of $3,000. Only $47,000 of the investment goes into the partnership but the investor's beginning basis is $50,000. If a partnership interest is sold, the gain or loss is the difference between the sales proceeds and adjusted basis at the time of sale, if, at the time of sale, the customer has unused losses ,these losses may be added to the cost basis. If a customer has an adjusted cost basis of $22,000 and unused losses of $10,000 and sells her partnership interest for $20,000, her loss on the sale would be $12,000

Required Documentation for Limited Partnerships

The certificate of limited partnership The partnership agreement The subscription agreement

Oil and Gas Sharing Arrangements

The costs and revenues associated with oil and gas programs are shared in a variety of ways. A description of these arrangements follows: -Overriding Royalty Interest. The holder of this interest receives royalties but has no partnership risk. An example of this arrangement is a landowner who sells mineral rights to a partnership. -Reversionary Working Interest. The GP bears no costs of the program and receives no revenue until LPs have recovered their capital. LPs bear all deductible and nondeductible costs. -Net Operating Profits Interest. The GP bears non of the program's costs but is entitled to a percentage of net profits. The LPs bear all deductible and nondeductible costs. This arrangement is available only in private placement. -Disproportionate Sharing. The GP bears a relatively small percentage of expenses but receives a relatively large percentage of revenues. -Carried Interest. The GP shares tangible drilling costs with the LPs but receives no IDCs. LPs receive the immediate deductions, whereas the GP receives write-offs from depreciation over the life of the property. -Functional Allocation. This is the most common sharing arrangement. The limited partnerships receive the IDCs, which allow immediate deductions. The GP receives the tangible drilling costs, which hare depreciated over several years. Revenues are shared.

Internal Rate of Return

The internal rate of return (IRR) is the discount rate (r) that makes the future value of an investment equal to its present value. You will not have to do any calculations with IRR. All you need to know is that it takes into consideration the time value of money and is a favorite method of evaluating a DPP.

DPPs Tax stuff..... Flow-Through

The key tax benefit of DPPs is that they allow the economic consequences of a business to flow-through to investors. Any income or loss to the investor is considered passive b/c the investor does not take an active role in the management of the business -- that is the role of the GP. Unlike corporations, limited partnerships pay no dividends. Rather, they pass income, gains, losses, deductions, and credits directly to investors. While each of the DPPs covered offer flow-through, some of the details are unique to each program.

Investors in a Limited Partnership

The limited partnership form of a DPP must involved both a GP and an LP.

DPP Compensation Restrictions

The rule places limits on the overall expenses and amount of BD compensation considered fair and reasonable. Specifically, if the organization and offering expenses exceed 15% of the gross proceeds, FINRA considers that too high. A subset of those expenses is the compensation to the member firm. That cannot exceed 10% of the gross proceeds. Included in the 10% is any compensation to wholesalers. Example: a DPP offering is sold in units of $10,000. It is prohibited for any member firm to participate in the offering if less than $8,500 is received by the issuer. Member compensation, including all participants in the sales chain, cannot exceed $1,000

Noncash Compensation

The rules on noncash compensation are the same as covered previously in unit 8. For example, gifts cannot exceed $100 per year. An occasional meal or ticket to a sporting event would be permitted.

Tax Concepts of DPPs

There are certain tax advantages to being structured as a partnership with the flow-through of income or loss being one of them. DPPs were formerly known as tax shelters b/c investors used losses to reduce or shelter ordinary income (by writing off passive losses against ordinary income.) Tax law revisions now classify income and loss from these investments as passive income and loss. Current law allows passive losses to shelter passive income, NOT all ordinary income as before. Many programs lost their appeal b/c of this critical change in tax law. As we learned in Unit 1, passive income is not considered earned income for the purpose of making an IRA contribution. The IRS considers programs without any economic viability to be abusive tax shelters. The promoters and investors can face severe penalties.

DPP Suitability

Under FINRA Rule 2310, all DPPs must have clearly stated standards of suit in the prospectus. In recommending a DPP to a customer, a member firm must be certain that the program is consistent with the customer's objectives and that the customer -is in a position to take full advantage of any tax benefits generated by the DPP -has a net worth sufficient to sustain the risks of the DPP, including loss of investment. The member, after making a suit determination, must maintain documents in its files describing the basis on which the determination of suitability was made. In addition, no member is permitted to execute a DPP transaction in a discretionary account without the prior written consent of the customer.

Oil and Gas Program Taxation

Unique tax advantages associate with oil and gas programs include intangible drilling costs (IDCs) and depletion allowances. Intangible Drilling Costs (IDCs) Write-offs for the expenses of drilling are usually 100% deductible in the first year of operation. These include costs associated with drilling such as wages, supplies, fuel costs, and insurance. IDCs can be defined as any cost that, after being incurred, has no salvage value. Tangible Drilling Costs TDCs are those costs incurred that have salvage value (storage tanks, and wellhead equipment). These costs are not immediately deductible; rather, they are deducted (depreciated) over several years. Depletion Allowances The IRS allows allowances in the form of tax deductions that compensate the partnership for the decreasing supply of oil or gas (or any other resource or mineral). Depletion is only allowed for natural resource programs. That includes timber and mining DPPs. ***Depletion allowances may only be taken once the oil or gas is sold. 2 forms of depletion, cost and percentage.

LPs allowed activities

Vote on changes to partnership investment objectives or the admission of a new GP Vote on sale or refinancing of partnership property. Receive cash distributions, capital gains, and tax deductions from partnership activities. Inspect books and records of the partnership Exercise the partnership democracy (vote under special circumstances, such as permitting the GP to act contrary to the agreement, to contest a judgement against the partnership, or admit a new GP.

Real Estate Program Taxation

When a DPP shows a loss, that loss can be used to offset passive income and save on taxes. In the case of a real estate program, expenses creating the losses are -mortgage interest expense -depreciation allowances for the "wearing out of the building" -expenses for improvement of the property In addition, there are two other benefits unique to real estate programs: -Nonrecourse debt adds to the investor's cost basis. -TAX CREDITS are offered for government assisted housing and historic rehabilitation projects. The advantage of a tax credit is that it reduces tax liability dollar-for-dollar. Example: An individual in the 30% tax bracket receives a tax deduction of $1,000. By lowering her income by $1,000, she saves $300 in tax. But if she received a $1,000 tax credit, she lowers her taxes by $1000

Measuring Economic Soundness

When it comes to evaluating a DPP, there are 3 factors in: Economic Soundness, Economic Soundness and Economic Soundness How is economic soundness or viability measured? 2 Methods applied to the analysis of DPPs are cash flow analysis and internal rate of return. -Cash flow analysis compares income (revenues) to expenses -Internal rate of return determines the present value of estimated future revenues and sales proceeds to allow comparison to other programs.

TTA** exam questions may test avoidance of corporate characteristics...

Which corporate characteristic is MOST difficult to avoid? -Centralized Management: no business can function without it. Which corporate characteristic is EASIEST to avoid? -Continuity of life: there is a predetermined time at which the partnership interest must be dissolved. Which two corporate characteristics are most likely to be avoided by a DPP? -Continuity of life and freely transferable interests: interests cannot be freely transferred; GP approval must transfer shares.