Unit 10

A client invests $100,000 in a tax shelter as a limited partner, giving him a 10% interest in the program. However, the general partners cannot meet the program's expenses. A mortgage balance of $3 million remains, and the property of the program is liquidated for $1 million. How much does the investor get back from his original investment? A) $0 B) $100,000 C) $33,000 D) $10,000

A) $0 The limited partner will not receive any return of his investment. In a failed program, the partnership's creditors are paid first with any sale proceeds—before the limited partners receive any money. Because the limited partners had not signed a recourse agreement, even though the partnership still owes $2 million on the mortgage, the limited partners are not liable for any money beyond their original investments.

From first to last, which of the following sequences reflects the priority of payments made when a limited partnership is liquidated? I. General partners II. Limited partners III. General creditors IV. Secured creditors A) IV, III, II, I B) IV, III, I, II C) I, IV, III, II D) I, II, III, IV

A) IV, III, II, I Creditors are paid first in a liquidation, with priority given to the secured lenders; general partners are the last to be paid.

Which of the following best describes an intangible drilling cost? A) Labor, fuel, or drilling rig rental B) Proven reserve of oil or gas C) Exploratory well drilling D) Tax liability

A) Labor, fuel, or drilling rig rental Intangible drilling costs are the noncapital costs of putting in a well. They are currently deductible expenses such as fuel, wages, and rent. An intangible drilling cost is one that, after expenditure, has no salvage value.

Although most REITs are traded actively in the secondary markets, an investor purchasing a nontraded mortgage REIT is exposed to which risk not found with others? A) Liquidity risk B) Business risk C) Default risk D) Interest rate risk

A) Liquidity risk When a REIT is nontraded, its liquidity is limited. Therefore, nontraded REITs should only be recommended to those clients who can afford liquidity risk. The other risks apply to traded and nontraded REITs.

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) Oil and gas drilling B) Real estate income C) Equipment leasing D) Undeveloped land purchasing

A) Oil and gas drilling 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.

Your client, Allyson, has consulted you regarding increasing the overall yield on her portfolio. It is currently invested almost entirely in domestic and foreign equity. She would like to reduce her risk exposure to equity securities. You have suggested real estate investment trusts (REITs) and explained that there are several different kinds of REITs. Which of the following accurately describes the characteristics of equity REITs? A) They earn rental income from leasing properties they own. B) They are most similar to open-end mutual funds. C) They earn interest income from mortgages on real estate properties. D) They are designed to be liquidated in a specific future year.

A) They earn rental income from leasing properties they own. Equity REITs own properties. Whether residential or commercial (think apartments, office buildings, or shopping centers), the tenants pay rent. After paying the expenses associated with operating their properties, equity REITs pay out annually the bulk (at least 90%) of the net income to their shareholders as dividends. Equity REITs can also generate capital gains from the sale of properties. Mortgage REITs receive interest income from mortgages they own. It is unusual for an equity REIT to pre-determine an ending date. REITs are more like closed-end funds than open-end ones because they trade in the secondary markets based on supply and demand. Allyson's risk reduction comes from the fact that there is a negative correlation to the general stock market. That means real estate prices and the stock market frequently move in opposite directions.

An investor wanting to know about the tax consequences of a direct participation program should know which asset types can be depleted or depreciated. All of the following asset types can be depleted or depreciated except A) crops. B) oil. C) gas. D) buildings.

A) crops. Oil and gas are examples of asset types that can be depleted, whereas buildings are a depreciable asset. Farm crops are considered renewable assets.

Real estate investment trusts (REITs) offer investors an opportunity to pool their money with others to receive professional management of real estate. Generally available types of REITs include all of the following except A) preferred REITs. B) equity REITs. C) hybrid REITs. D) mortgage REITs.

A) preferred REITs. While some corporations may issue preferred stock, there is no such term as a preferred REIT. Equity REITs take ownership positions in real estate properties. Mortgage REITs make loans to real estate properties. Hybrid REITs do both.

All of the following characteristics are advantages of a real estate investment trust (REIT) except A) tax deferral. B) diversification. C) liquidity. D) professional management.

A) tax deferral. A REIT is a professionally managed company that invests in a diversified portfolio of real estate holdings. REITs are traded on exchanges and over the counter, which provides liquidity. The IRS does not permit tax deferrals on REIT investments.

Limited partnership programs are categorized as direct participation programs. The term direct participation refers to A) the flow-through of profits and losses of the partnership to the individual limited partners. B) the ability, through the partnership democracy, for each partner to have her vote flow through to the general partner. C) the general partners directly participating in the day-to-day management of the partnership. D) the ability of any partner, limited or general, to participate in the running of the partnership.

A) the flow-through of profits and losses of the partnership to the individual limited partners. Understanding the flow-through concept is critical with DPPs. Only DPPs allow flow-through of losses.

What might happen if a limited partner begins making business decisions for the partnership? A) There would be no effect because of the partnership democracy. B) He might jeopardize his limited liability status. C) He may be removed from the partnership completely. D) He ascends to general partnership status as a reward for his decision-making contribution.

B) He might jeopardize his limited liability status. If a limited partner has control over the partnership operation (i.e., he makes partnership decisions), he could be judged a general partner and, thus, have unlimited liability.

Which of the following terms or phrases does not apply to real estate investment trusts (REITs)? A) Managed B) Redeemable C) Dividends taxed at full ordinary income rates D) Secondary market

B) Redeemable REITs trade in the secondary market and are not redeemable. The real estate portfolio is actively managed, and dividends paid by REITs do not meet the requirements to be taxed as qualified dividends; therefore, they are taxed as ordinary income.

There are various direct participation program offerings giving investors a range of choices of different types of oil and gas drilling opportunities. All of the following are types of oil and gas direct participation programs except A) income. B) functional allocation. C) exploratory D) developmental.

B) functional allocation. Functional allocation is the most common form of revenue sharing. It is not a type of program. There are three basic types of programs. The first type of basic program is exploratory, sometime called wildcat, which is drilling in an unproven area. The next is development where an existing field is continuing to be developed by additional drilling. Finally, there are the income (sometimes called production) programs that purchase producing wells. There are some program sponsors who split the proceeds from the offering into two or three of these types making it a combination program.

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

B) nonrecourse loans. Nonrecourse loans only have economic consequences for investors in real estate programs.

An investor in an equipment-leasing direct participation program (DPP) using straight-line depreciation would probably not be concerned about A) liquidity risk. B) the likelihood of recapture. C) the quality of the management. D) legislative risk.

B) the likelihood of recapture. Recapture of deductions is a concern when accelerated, but not when straight-line depreciation is used. In any business, there is always concern about the quality of the management. By and large, DPPs are not liquid investments, so an investor needing a quick sale may have problems. The nature of DPPs tends to make them more sensitive to legislative risk than most other securities.

Limited partners in a real estate partnership have all of the following rights except A) the right to monitor the partnership on an ongoing basis. B) the right to decide which properties the partnership purchases. C) the right to sue the general partner for violating the partnership agreement. D) the right to receive their pro rata share of income or loss.

B) the right to decide which properties the partnership purchases. The limited partners have the right to inspect partnership records and the right to sue a general partner who acts outside the partnership agreement. The general partner normally sets her own compensation in the original agreement and makes all management decisions relative to the partnership's interests.

Which of the following statements regarding limited partnerships are true? I. The maximum commission in selling partnership offerings is 5%. II. The maximum commission in selling partnership offerings is 10%. III. Commissions taken are deducted from the original investment to determine beginning cost basis. IV. Commissions taken are not deducted from the original investment to determine beginning cost basis. A) I and III B) I and IV C) II and IV D) II and III

C) II and IV Under FINRA rules, the maximum compensation that can be taken by sponsors selling direct participation programs is 10%. Up-front costs, such as commissions taken and accounting costs, do not reduce the beginning cost basis.

In discussing a direct participation program with your customer, she notes investment characteristics that are important to her and some that are not. For a DPP to be considered suitable for the customer, rank the following items in order of those that should be most important to those that should be least important. I. Tax write-offs II. Liquidity and marketability III. Potential for economic gain IV. SEC approval A) III, IV, II, I B) I, II, III, IV C) III, I, II, IV D) II, III, IV, I

C) III, I, II, IV In the eyes of the IRS, a program's economic viability should be the most important aspect of the investment for a limited partner and the first priority in the assessment of the DPP. While the IRS considers programs designed solely to generate tax benefits abusive, they do allow for some in terms of writing off passive income and allowable tax credits, so these factors would be the next concern for an investor. Because there is a very limited secondary market for DPPs, liquidity and marketability should be a low priority, and because there is no SEC approval of any investment, it would be of no concern.

Which of the following statements regarding real estate investment trusts (REITs) is not correct? A) REITs manage portfolios of real estate investments to earn profits and/or income. B) REITs offer professional management and diversification. C) REITs are typically not publicly traded. D) REITs pool capital in a manner similar to an investment company.

C) REITs are typically not publicly traded. REITs are typically publicly traded and serve as a source of long-term financing for real estate projects. A REIT is a company that manages a portfolio of real estate investments to earn profits and/or income for its shareholders. Like many other pooled investment vehicles, REITs offer professional management and diversification. A REIT pools capital in a manner similar to an investment company.

When a limited partnership interest is sold, gain or loss to the partner is determined by the difference between the sales proceeds and the A) original cost basis. B) total of deductible losses. C) adjusted cost basis. D) original investment minus any debt assumed by the general partner(s).

C) adjusted cost basis. As with any item, gain or loss is determined by comparing proceeds to cost. In the case of a limited partnership program, the cost for tax purposes is usually subject to a number of adjustments and may be higher or lower than the original investment.

Advantages of owning a real estate DPP program include all of the following except A) depreciation. B) cash flow. C) depletion. D) appreciation.

C) depletion. Depletion only applies to natural resources, such as oil or gas. Land does not get used up as do oil, gas, or coal.

The managing partner of a limited partnership has responsibility for all of the following except A) organizing the business. B) paying partnership's debts. C) providing unlimited capital for the partnership business. D) managing the operations.

C) providing unlimited capital for the partnership business. The general partner organizes and manages the partnership; he assumes unlimited liability, paying all partnership debts. However, it is the limited partners who provide the bulk of the capital.

When a DPP reaches the crossover point, A) the general and limited partners have earned income. B) there are no further commissions paid to broker-dealers who sold units. C) the general partners have earned income while the limited partners have passive income. D) any assets have been fully depreciated.

C) the general partners have earned income while the limited partners have passive income. The crossover point is defined as the point at which the DPP begins to generate taxable income. That is, revenues now exceed expenses. This income is earned income for the general partner(s) and passive income to the limited partner(s).

Your client invests $20,000 to purchase a 10% interest in a movie production limited partnership. At the time of subscribing, the investor signs on an $800,000 recourse loan to the partnership. After completing the first year of operations, the program shows a loss of $1,200,000. All of the following statements are correct except A) the investor's basis is now $0.00. B) the investor has a passive loss deduction of $100,000. C) the investor's original basis was $20,000. D) the investor's original basis was $100,000.

C) the investor's original basis was $20,000. Let's take this step by step. The original check for $20,000 is all cost basis. But, it doesn't stop there. When becoming a limited partner, the investor signed on to the recourse loan. The 10% share of that loan is $80,000, bringing the initial basis up to $100,000. When the end-of-year report shows a loss of $1,200,000, it would appear that the investor takes 10% of that ($120,000) as a passive loss. The problem is that IRS rules do not allow a loss greater than the investor's basis (in this case, $100,000). Once that loss is taken, the basis is wiped out. The extra $20,000 may be carried forward. Unless the investor contributes more money, or the partnership has earnings, this investor cannot use that $20,000 or any further losses.

An investor is interested in a limited partnership and asks his registered representative to explain the crossover point referred to in discussions about the tax consequences of the program. The best definition would be A) the point at which the program begins to generate taxable income instead of losses, which generally occurs quickly if not in the very first year. B) the point at which the program begins to generate losses instead of taxable income, which generally does not occur until near the time the partnership is expected to be dissolved. C) the point at which the program begins to generate taxable income instead of losses, which generally occurs in later years. D) the point at which the program begins to generate losses instead of taxable income, which generally occurs in later years.

C) the point at which the program begins to generate taxable income instead of losses, which generally occurs in later years. The crossover point is the point at which the program begins to generate taxable income instead of losses. This generally occurs in later years when income increases and deductions decrease. Most partnerships are scheduled to end at or near to the crossover point because of the diminished tax advantages.

FINRA Rule 2310 defines a direct participation program as "a program which provides for flow-through tax consequences regardless of the structure of the legal entity or vehicle for distribution including, but not limited to, oil and gas programs, real estate programs, agricultural programs, cattle programs, condominium securities, Subchapter S corporate offerings and all other programs of a similar nature, regardless of the industry represented by the program, or any combination thereof." The rule places limits on the amount of broker-dealer sales compensation considered fair and reasonable. That limit is A) 15% of the gross proceeds. B) 2% of the gross proceeds. C) 5% of the gross proceeds. D) 10% of the gross proceeds.

D) 10% of the gross proceeds. FINRA limits the amount of the sales compensation to 10% of the gross proceeds of the offering. If the organization and offering expenses exceed 15% of the gross proceeds, FINRA considers that too high. The 2% is the maximum charge in a DPP rollup if the firm wishes to solicit votes from the limited partners. The 5% is the FINRA markup policy and that does not apply to DPPs.

An investment banking firm has been hired to roll up various partnerships into one master limited partnership. What is the compensation limit for this activity? A) 5% B) 10% C) 8.5% D) 2%

D) 2% Maximum compensation in a limited partnership rollup is limited to 2%. That amount must be paid to the brokerage firm, whether the partners vote for or against the proposed rollup.

Regarding the use of the term direct participation programs (DPPs) when referring to tax-sheltered investments, which of the following is not a DPP? A) An equipment-leasing limited partnership B) An oil and gas limited partnership C) A real estate limited partnership D) A real estate investment trust (REIT)

D) A real estate investment trust (REIT) DPPs include any form of business that allows for the direct pass-through of tax consequences to participants. REITs do not allow for the pass-through of losses.

Which of the different sharing arrangements for limited partnerships between the general partners (GPs) and the limited partners (LPs) is generally considered the most common? A) Overriding royalty interest B) Net operating profits interest C) Carried interest D) Functional allocation

D) Functional allocation While both LPs and GPs share equally in the revenues with a functional allocation arrangement, it is most commonly used because it gives the best tax benefits to each. The LPs receive the immediate tax write-offs from the intangible drilling costs, whereas the GPs receive continued write-offs from the tangible costs over the course of several years.

Which of the following could an analyst use to establish the rate of return on a direct participation program (DPP)? I. Present value II. Internal rate of return III. Yield to maturity IV. First-in, first-out A) II and III B) I and IV C) III and IV D) I and II

D) I and II Analysts use both present value and internal rate of return to establish a DPP's rate of return. Both involve assumptions based on future cash flows generated by the program.

An experienced investor wants to allocate 10% of an existing portfolio to owning real estate but does not want to maintain properties, be a landlord, or wait if cash is needed. Which of the following choices would be suitable, given the investor's objectives? A) Purchase shares of mortgage companies B) Purchase property and assign a management company C) Purchase shares of a mortgage REIT D) Purchase shares of an equity REIT

D) Purchase shares of an equity REIT Equity real estate investment trusts (REITs) are a way to have an ownership interest in real estate without having to manage properties or worry about collecting rents. REITs trade on exchanges and over the counter; therefore, they are liquid investments. Both of these characteristics meet the investor's objective and make equity REITs the most suitable recommendation of those offered here. A mortgage REIT does not own real estate, so it will not meet the investor's objective.

Which of the following is an equity security? A) Government National Mortgage Association pass-through certificate B) Collateralized mortgage obligation C) Mortgage-secured bond D) Real estate investment trust (REIT) share

D) Real estate investment trust (REIT) share A REIT share is an equity security that represents undivided ownership in a portfolio of real estate investments. The other choices are debt securities.

A method of analyzing limited partnerships by identifying the sources of revenues and expenses is known as A) technical analysis. B) capital analysis. C) liquidity analysis. D) cash flow analysis.

D) cash flow analysis. Cash flow analysis compares income (revenues) to expenses.

imited partners have the right to do all of the following except A) sue the general partners for damages if he acts outside of his authority. B) inspect and copy partnership records. C) vote to remove the general partners. D) choose the assets for the partnership.

D) choose the assets for the partnership. All of these are rights of the limited partner except choosing the assets to be purchased for the partnership, which is a function of the general partner.

Flow-through of income and loss is a feature of A) real estate investment trusts (REITs). B) exchange-traded funds (ETFs). C) unit investment trusts (UITs). D) direct participation programs (DPPs).

D) direct participation programs (DPPs). It is only the DPP where both income and losses pass through to the investor. In the other investments, they are required to pay out at least 90% of their net investment income to investors to maintain their special tax status as regulated investment companies under the Internal Revenue Code. Notice, it is only income that passes through, not losses.

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

D) he and the general partner have both signed the subscription agreement. 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.

All of the following are common to both DPPs and REITs except A) centralized management. B) capital gains distributions. C) pass-through of income. D) pass-through of losses.

D) pass-through of losses. Both DPPs and REITs are professionally managed pools that pass through income and capital gains distributions to participants. REITs, unlike DPPs, do not pass through losses.

Depreciation expense is a deduction for investors in all of the following except A) movie production limited partnerships. B) real estate limited partnerships (RELPs). C) equipment leasing limited partnerships. D) real estate investment trusts (REITs).

D) real estate investment trusts (REITs). REITs are not flow-through vehicles. That tax treatment is available to limited partnership investments. If the REIT owns depreciable property, it will take the deduction but the investor will not.

The rights and liabilities of general and limited partners are listed in A) the Uniform Limited Partnership Act. B) the certificate of partnership. C) the partnership title. D) the partnership agreement.

D) the partnership agreement. The agreement is the contract between the general and limited partners, and it contains each entity's rights and duties. The certificate of partnership is the document legally establishing the enterprise.

In a direct participation program (DPP) limited partnership, the general partner has A) limited liability and a passive role. B) limited liability and an active role. C) unlimited liability and a passive role. D) unlimited liability and an active role.

D) unlimited liability and an active role. In a DPP limited partnership, the general partner is the active partner managing the business who assumes unlimited liability. Limited partners who take an active role jeopardize their limited liability status.