Series 7: Taxes and Tax Shelters (Tax Advantaged Investments)

A limited partner has a year beginning partnership cost basis of $40,000. The partner's K-1 for this year shows a cash distribution of $10,000 representing a return of principal, and depletion charges of $5,000. The partner's year end adjusted tax basis is?

$25,000 A cash distribution from the partnership reduces that partner's cost basis. Similarly, the partner's distributive share of any losses reduces his cost basis. Thus, the partner's basis is reduced by both the $10,000 cash distribution and the $5,000 depletion allowance. Since the beginning basis was $40,000; and the deductions total $15,000; the year end basis will be $25,000.

A customer buys a real estate limited partnership interest by contributing $20,000 and signing a $20,000 non-recourse note. The customer's tax basis is:

$40,000 Normally, financing for which investors are not at risk (non-recourse financing), is excluded from the basis. However, real estate programs are exempt from the at risk rule. Thus, the $20,000 cash contribution and the $20,000 non-recourse note are included in the beginning basis for a real estate program.

A customer invests $500,000 in a limited partnership for a 20% interest. The partnership takes a loan for $10,000,000, for which each of the partners has signed and is personally liable. The partnership liquidates and $8,000,000 of the debt is paid off from the proceeds. The limited partner's remaining liability is:

$400,000 The partnership has liquidated and $2,000,000 of the debt remains unpaid. The partner is personally liable for 20% of this debt or $400,000. (Note: The partner's original investment of $500,000 cash has already been applied to pay off claims in the liquidation).

The syndicator of a limited partnership is the individual who:

handles the organization of the partnership and registration of the securities The syndicator of a limited partnership is the person who handles the organization of the partnership and the registration of the partnership securities.

A non-leveraged Direct Participation Program has all of the following risks EXCEPT:

interest rate risk If a direct participation program is "non-leveraged," then none of the purchase amount is financed. In a leveraged direct participation program, part of the purchase amount is financed - often at a variable rate. If interest rates rises, the interest rate on the loan increases - a form of interest rate risk. Thus, a non-leveraged direct participation program would not have this risk. All direct participation programs are subject to liquidity risk (since these are not traded and are not easily sold); management risk; and legislative risk.

All of the following are disadvantages of investing in Direct Participation Programs EXCEPT the:

investor's liability is limited to the amount of cash invested and his or her share of recourse financing The limited liability offered to investors in limited partnerships is the main advantage of these programs. Limited liquidity; greater chance of IRS audit; and the fact that the investor has little or no say in the management are all disadvantages.

A direct participation program offering which is "managed:"

is offered by a syndicate on a firm commitment basis Managed direct participation program offerings are firm commitments by underwriters who buy the issue and then sell it to the public through a syndicate - the underwriter is said to be "managing" the sale of the offering. An unmanaged direct participation program is one which is sold to investors through wholesalers, acting as agents for the issuer. These offerings are sold on a best efforts basis. The wholesalers take no financial responsibility for the issue.

A direct participation program offering which is "unmanaged:"

is offered through sellers on a best efforts basis An unmanaged direct participation program is one which is sold to investors through wholesalers, acting as agents for the issuer. These offerings are sold on a best efforts basis. The wholesalers take no financial responsibility for the issue. Managed direct participation program offerings are firm commitments by underwriters who buy the issue and then sell it to the public through a syndicate - the underwriter is said to be "managing" the sale of the offering.

All of the following fees associated with limited partnership syndications are non-deductible from partnership income EXCEPT:

management fees Management fees charged to a limited partnership are deductible from partnership income. Start-up costs are not deductible from partnership income. These are included in the partner's cost basis and remain there without change. These start-up costs include organization costs; the spread paid to underwriters by the issuer; and initial accounting and legal costs.

All of the following are "front end" fees that are deducted from the gross investment made in a limited partnership EXCEPT:

operating costs The "up-front" costs that are incurred in a limited partnership are the selling fees; organization costs; and legal and accounting expenses for establishing the partnership. For example, assume a prospectus for a $10,000 partnership interest shows the following: $10,000Unit$ 1,000Selling Expenses$ 500Organizational Costs$ 500Legal and Accounting Costs$ 8,000Net Proceeds Invested in Partnership Assets Of the $10,000 invested, $2,000 of expenses were incurred to establish the partnership, while only $8,000 was invested productively. Please note that these items are not deductible for tax purposes from the partner's income as an expense. Rather, they are incorporated into the beginning partnership basis. Any operating expenses incurred during that year would be deductible at the end of the year against the beginning basis. They are not an "up-front" cost.

Limited partnership investors are subject to all of the following risks EXCEPT:

prepayment risk Limited partnership investors suffer from marketability risk, since such securities are illiquid. They also suffer from the risk of further tax law changes, and increased chances of tax audits. There is no prepayment risk associated with these securities; this is a risk that is associated solely with mortgage backed pass-through certificates.

A written financial statement is required from a customer who wishes to:

purchase a direct participation program interest Under the FINRA Conduct Rules, a registered representative must obtain detailed financial disclosure from any customer that wishes to purchase a direct participation program interest, in order to determine that such a "tax sheltered" investment is suitable for the customer.

Modified Accelerated Cost Recovery System (MACRS) deductions are NOT available for which of the following assets?

real property Real property must be depreciated on the straight line method over 27 1/2 years (for residential property). Tangible property, such as equipment, aircraft, and oil rigs qualifies for accelerated depreciation deductions under the Modified Accelerated Cost Recovery System.

"Phantom income," in a limited partnership: I can occur when the partnership abandons an asset on which there is an outstanding loan II can occur when the partnership abandons an asset on which there is no outstanding loan III is taxable income IV is not taxable income

I and III "Phantom income" is a rather nasty IRS concept that states that if a loan is forgiven, the amount of the unpaid loan becomes taxable income to the beneficiary. If a partnership loan is forgiven, (or partially forgiven, for example when an asset is given to the lender in return for forgiveness of the loan), "phantom income" is generated to the extent that the loan balance exceeds the asset's market value. "Phantom income" is taxable income, even though no actual cash income is received by the beneficiary.

A general partner refinances an existing housing limited partnership by obtaining a new 10%, $1,000,000, 30 year mortgage on the property. The general partner is using the proceeds to pay off the old 10%, $700,000, 15 year mortgage. Which statements are TRUE? I The interest expenses allocable to the limited partners will increase II The interest expenses allocable to the limited partners will decrease III The limited partner's tax basis in the venture increases IV The limited partner's tax basis in the venture decrease

I and III By refinancing the building with a larger mortgage ($1,000,000 new mortgage, replacing the old $700,000 mortgage), the general partner is obtaining $300,000 of extra cash that can be distributed to the limited partners. Since there is a higher mortgage balance, the interest expenses allocable to the limited partners will increase (not decrease). The higher mortgage balance increases the limited partners' basis (non-recourse financing adds to the basis in real estate investments). As the basis increases, the total amount of potential deductions that may be taken increases.

The certificate of a limited partnership would contain which of the following? I The name of the partnership and its purpose II Partnership address III The names of each limited and general partner with their percentage ownership IV The life of the partnership

I, II, III, IV All of the items listed are included in the Certificate of Limited Partnership. The certificate of limited partnership is filed with the State to establish the partnership as a legal entity doing business in the State. It contains the name and address of the partnership; its purpose; the life of the partnership; as well as the names of the limited and general partners along with their percentage ownership.

When evaluating an investment in a limited partnership, an investor should consider which of the following? I Economic soundness of the program II Program objectives III Sponsor track record IV Sponsor conflicts

I, II, III, IV An investment in a limited partnership should be made based on the economic merits of the program - an investment made solely for tax benefits can easily result in an after tax loss to the partners. The factors to consider when evaluating a program are: the economic soundness of the program; program objectives; sponsor track record; sponsor compensation; sponsor conflicts; and before and after tax return projections of the project.

Which of the following are types of real estate direct participation programs? I New Construction Real Estate Limited Partnership II Existing Housing Real Estate Limited Partnership III Raw Land Real Estate Limited Partnership IV Condominium Investment Limited Partnership

I, II, III, IV Direct participation programs allow the partners to directly participate in income and loss. Types of RELPs (Real Estate Limited Partnerships) are: New Construction; Existing Housing; Raw Land: and Condominium investments.

If the IRS considers a tax shelter to be abusive, which of the following can happen? I Tax deductions are disallowed II Interest and penalties are charged on the tax due III Any tax refund claims will be withheld by the IRS IV The IRS can charge the tax shelter promoter and investors with fraud

I, II, III, IV If the IRS considers a tax shelter to be abusive, watch out! The investor is liable for back taxes plus interest and penalties; any current tax refund claims made using tax shelter deductions will be withheld by the IRS; and the partners can be charged with intent to defraud the government.

Which of the following are major tax benefits of real estate limited partnerships? I The real estate can be depreciated, even if its market value is increasing II Non-recourse financing is included in the basis III Interest on loans is fully deductible IV Long term capital gains may be achieved when the real estate is sold

I, II, III, IV The major tax benefits of real estate programs include all of the choices. Once property is ready for occupancy, it can be depreciated over a straight line basis over a 27 1/2 year life (for residential property). Each year, a depreciation deduction is allowed, even if the market value of the property is rising. Non-recourse mortgage financing is included in the basis (real estate is exempt from the "at risk" rule) and increases overall deductions available to the partner. Interest on the mortgage is fully deductible. Finally, when the property is sold, there is the possibility of having a long term capital gain.

Which of the following items are taxable to a limited partnership? I Short Term Gains II Long Term Gains III Ordinary Income

None of the above Partnerships are not taxable entities; all items of income and loss "flow through" to the tax returns of the partners. Tax liability only exists at the partner level - not at the partnership level.

A customer buys an oil and gas limited partnership interest for $20,000 and signs a $10,000 recourse note. After the first year of operations, the investor's K-1 shows: Revenue$30,000 Operating Expenses$17,000 Debt Service - consisting of $5,000 principal repayment and $3,000 interest$. 8,000 Management Fees$ 5,000 Depreciation$ 2,500 Percentage Depletion$ 4,500 The net cash flow from partnership operations for this year is:

0 Net cash flow is found by deducting the cash outlays from revenues. The cash outlays are: Revenues$30,000 Operating Expense$17,000 Debt Service$ 8,000 Management Fees$ 5,000 Net Cash Flow$ 0 Notice that depletion and depreciation are excluded because these are non-cash items. Also notice that the entire debt service amount, including principal repayment, is included because these are cash items.

Which statement best describes an oil and gas program disproportionate sharing arrangement?

The general partner bears a proportionate share of all costs for a greater percentage of oil revenues Choice A describes a disproportionate sharing arrangement. In a disproportionate sharing arrangement, the general partner agrees to bear some costs in return for a much greater percentage of oil revenue. Choice B describes a functional allocation sharing arrangement. In a functional allocation oil and gas sharing arrangement, the limited partners get the intangible drilling cost deductions (100% deductible in the year drilling occurs) while the general partner bears the costs that are not immediately deductible (tangible costs). Choice C describes an overriding royalty interest. In an overriding royalty interest, the general partner takes a percentage from the first barrel produced, without regard to costs. Choice D describes a reversionary working interest. In a reversionary working interest (also called a subordinated royalty interest), the general partner agrees not to take a percentage of revenue until all costs are recovered. q

In an oil and gas program with a reversionary working interest sharing arrangement, which statement is TRUE?

The general partner defers taking a percentage of oil revenues until all costs laid out by the limited partners are recovered Choice A describes an overriding royalty interest. In such a sharing arrangement, the limited partners bear all costs and the general partner puts up nothing. The general and limited partners share oil revenue from the first barrel sold. Choice B describes a functional allocation sharing arrangement. In such a sharing arrangement, the limited partners bear the immediately deductible intangible drilling costs, while the general partner bears the tangible costs (recovered through depreciation over a period of time). Choice C doesn't exist. Choice D describes a "reversionary working interest" sharing arrangement, where the general partner puts up nothing, and the limited partners pay for everything. However, the general partner defers taking his or her percentage of oil revenue until all limited partner costs are recovered.

In an oil and gas program which has an overriding royalty interest arrangement, which statement is TRUE?

The general partner takes a percentage from the first barrel of oil produced, without regard to costs In an overriding royalty interest, the general partner takes a percentage from the first barrel produced, without regard to costs. In a net profits interest, the general partner gets a percentage of defined "net profits" from the first barrel produced, but "net profits" as defined usually does not deduct all costs. These arrangements are all "carried interests" because the general partner does not contribute to the cost of finding oil. In a reversionary working interest (also called a subordinated royalty interest), the general partner agrees not to take a percentage of revenue until all costs are recovered. In a disproportionate sharing arrangement, the general partner agrees to bear some costs in return for a much greater percentage of oil revenue. This is a "working" interest.

Which of the following would be described as a blind pool limited partnership?

The partnership investments are not known at the time of the offering A blind pool is one where the specific investments of the partnership are not known at the time the partnership is formed. The actual investments are selected later. While this may sound like a way to buy a "pig in a poke," it is not conceptually different from buying a mutual fund, where the specific investments made by the manager are not known either!

If the alternative minimum tax computation is less than the regular income tax computation, which statement is TRUE?

The regular amount is due Under the tax law, each tax filer must compute both the regular income tax and the alternative minimum tax (known as the "tax on tax preferences"), and must pay the higher amount.

A customer invests $10,000 in an oil and gas drilling program and signs a $20,000 recourse note. Which statement is TRUE?

The tax basis is $30,000 An investor is personally liable for recourse financing. He or she is "at risk" for this amount. Under the "at risk rule," only amounts for which an investor is personally at risk can be included in the basis (however real estate is exempted from the "at risk" rule). The tax basis consists of the $10,000 paid in cash and the $20,000 recourse note.

Which statement is TRUE about forming a limited partnership?

There must be at least 1 general partner and 1 limited partner A limited partnership consists of at least one General Partner and one Limited Partner. There can be multiples of each. The General Partner is the manager of the venture and assumes unlimited liability. The Limited Partner is the passive investor whose liability is limited to his or her investment.

To form a limited partnership, there must be at least:

1 limited partner and 1 general partner A limited partnership consists of at least one General Partner and one Limited Partner. There can be multiples of each. The General Partner is the manager of the venture and assumes unlimited liability. The Limited Partner is the passive investor whose liability is limited to his or her investment.

Under FINRA rules, maximum underwriter's compensation for selling direct participation programs is generally limited to:

10% To be fair and reasonable, generally the maximum spread that can be taken by underwriters in limited partnership offerings is 10% of the purchase price

A customer buys a Direct Participation Program by investing $200,000; and signing a $200,000 non-recourse note. The partnership immediately liquidates, and the investor is returned $100,000 by the general partner. The investor has:

a $100,000 capital loss The customer's beginning tax basis is $200,000 in the partnership (the non-recourse financing is not included in the basis since the partner is not personally "at risk" for this). If the partnership immediately liquidates and the partner is returned $100,000, this represents his "sale proceeds" for tax purposes. The capital gain or loss is: $200,000 basis - $100,000 sale proceeds = $100,000 loss.

A partnership disposes of a tangible item (such as property) after having taken depreciation deductions on it. Upon sale of the item, these deductions are added back to the sale proceeds for tax purposes. This is known as:

recapture Depreciation is a tax benefit. Recapture rules require that those benefits be "recaptured" and taxed as ordinary income if the asset that was the subject of the benefits is sold at a gain. Phantom income arises when a debt is forgiven by a lender - the amount of the forgiven debt is "phantom income" to the investor and is taxable. The alternative minimum tax (AMT) is the "tax on tax preferences." If someone uses tax benefits such as depreciation and depletion too heavily, reducing taxable income to very low levels; then the AMT kicks in and requires that a minimum tax be paid on income, adding back these tax preference items.

An oil and gas sharing arrangement where the general partner agrees to defer taking a percentage of revenues until all costs are recovered is a(n):

reversionary working interest In a reversionary working interest (also called a subordinated royalty interest), the general partner agrees not to take a percentage of revenue until all costs are recovered. In an overriding royalty interest, the general partner takes a percentage from the first barrel produced, without regard to costs. In a net profits interest, the general partner gets a percentage of defined "net profits" from the first barrel produced, but "net profits" as defined usually does not deduct all costs. These arrangements are all "carried interests" because the general partner does not contribute to the cost of finding oil. In a disproportionate sharing arrangement, the general partner agrees to bear some costs in return for a greater percentage of oil revenue. This is a "working" interest.

A well that is drilled on leases adjacent to proven reserves is known as a:

step-out well A "step-out" well steps out from an existing field to drill in an adjacent area. These are used in developmental oil programs.

An investor is considered to be a limited partner when the:

subscription agreement is accepted by the general partner The subscription agreement essentially is an "application" by an investor to become a limited partner in the venture. It includes a financial profile of the investor, along with a signed statement that the investor understands the risks and merits of the offering; and is financially capable of handling this illiquid investment. An investor becomes a limited partner when the general partner accepts the limited partner by signing the subscription agreement.

In order to determine whether a direct participation program is a suitable investment for a customer, inquiry should be made into all of the following EXCEPT:

the customer's need for tax deductions in previous years An investor buys a limited partnership interest for tax benefits in future years. The investor's need for tax benefits in prior years is irrelevant.

All of the following are types of oil and gas direct participation programs EXCEPT:

Balanced Exploratory oil and gas programs drill for oil in unproven areas. Developmental programs drill near existing fields. Income programs simply buy proven oil reserves in the ground, and sell them using the depletion allowance as a partial tax shelter. Combination programs combine all three types. There is no such thing as a "balanced" oil and gas program. This term only applies to investment company portfolio descriptions.

A type of limited partnership where the specific investments of the partnership are not known at the time the partnership is formed is known as a(n):

Blind pool limited partnership A blind pool is one where the specific investments of the partnership are not known at the time the partnership is formed. The actual investments are selected later. While this may sound like a way to buy a "pig in a poke," it is not conceptually different from buying a mutual fund, where the specific investments made by the manager are not known either!

Which of the following features is common to BOTH real estate limited partnerships and real estate investment trusts?

Centralized management Both real estate limited partnerships and real estate investment trusts have centralized management. In a partnership, management is performed by the general partner. REITs have a Board of Trustees that oversee operating management. Only real estate limited partnerships (RELPs) have "partners" - REITs issue stock. In a RELP, non-recourse debt used to purchase real estate adds to the partners' individual basis. There is no similar tax treatment for REITs. RELPs pass through tax losses to partners; REITs cannot pass losses to shareholders - only gains are subject to conduit tax treatment.

Which type of real estate limited partnership offers an immediate depreciation benefit?

Existing Housing Raw land is not depreciable; only the building on the land is depreciable. Existing housing is immediately depreciable. New construction is only depreciable after the building is completed - during the building phase, no depreciation deductions are permitted.

In a liquidation of a limited partnership, which of the following is paid last?

General Partners In a limited partnership liquidation, secured creditors are paid first; second are general creditors; then limited partners; and finally general partners are paid.

Which of the following are conflicts of interests in limited partnership offerings? I General partners accepting loans from the partnership II General partners competing with the partnership III Limited partners competing with the partnership IV General partners receiving a disproportionate share of partnership income

I and II The general partner accepting loans from the partnership or competing with the partnership are both conflicts of interest. Limited partners are free to compete with the partnership since they are passive investors. It is common for general partners to receive a greater percentage of income because of the expertise that they contribute to the partnership.

Advantages of leveraged limited partnerships include all of the following EXCEPT:

the investor's loss is limited to his cash investment if recourse financing is used In a leveraged limited partnership, the limited partner is liable not only for his cash investment, but for any recourse notes that he has signed. The limited partner is not personally liable for non-recourse financing since the lender only has claim to the property to satisfy the debt (not to the limited partner personally). If the investor has signed a recourse note, he is liable for the amount of the note above and beyond his cash investment.

Under partnership democracy provisions, the partnership agreement must give detailed disclosure of all of the following EXCEPT:

the procedures for allowing limited partners to assign specific properties Limited partners cannot assign properties or perform management functions. Performing these actions would cause that person to be viewed as a general partner - who takes on unlimited liability. Partnership agreements will include provisions on allocating profits; compensation to the general partner; and claim to assets upon dissolution.

An "unmanaged" direct participation program is sold to investors by the:

underwriter An unmanaged direct participation program is one which is sold to investors through wholesalers, acting as agents for the issuer. These offerings are sold on a best efforts basis. The wholesalers take no financial responsibility for the issue. Managed direct participation program offerings are firm commitments by underwriters who buy the issue and then sell it to the public through a syndicate - the underwriter is said to be "managing" the sale of the offering.

A limited partnership is formed between two individuals - one acting as the general partner; the other as the limited partner. The general partner wants the limited partner to solicit new investors to become limited partners in the venture. This action by the limited partner would:

cause the limited partner to be viewed as a general partner - and this individual would assume unlimited liability If a limited partner takes any role in participating in the running of the business, he or she is viewed as a general partner and assumes unlimited liability. To retain limited liability, the limited partner must remain a passive investor.

The Internal Rate of Return of a limited partnership:

considers the time value of money to find the rate of return to investors The evaluation method used for direct participation programs that considers the time value of money is the "Internal Rate of Return" (IRR). This method finds the implicit interest rate that discounts the projected cash flows from the program to a present value of "0." This interest rate represents the implicit rate of return that the program is expected to return. It is not a guarantee of return on investment.

When a limited partnership's taxable income exceeds partnership losses, this is known as the:

crossover point The crossover point in a limited partnership occurs when taxable income exceeds loss deductions. The cross-over point happens when either income increases from the program; or tax deductions fall off from the program (or some combination of both).

A customer invests $100,000 in a real estate limited partnership. In the first year of operations, the investor is allocated $20,000 of income; $80,000 of interest deductions; $45,000 of operating expenses; and $25,000 of depreciation expense. Assuming that the investor has sufficient passive income, this investor may deduct a net loss of how much from his tax return for this year?

$100,000 The partnership's net loss from operations for this year is: Income:$20,000 Expenses:Interest$80,000 Operating$45,000 Deprec.$25,000 Net Loss$130,000 Since the beginning basis is $100,000, this amount may be deducted for this tax year. (remember, one can never deduct more than the basis). Of the net loss of $130,000, only $100,000 can be deducted, bringing the year end basis to "0." The unused $30,000 loss is carried over to the next tax year and may be deducted if the basis increases to at least this amount during that year.

An investor contributes $75,000 of cash to a partnership and signs a $50,000 recourse note. During the first year, the investor is allocated partnership income of $50,000, debt service expense of $20,000 consisting of $15,000 of interest and $5,000 of principal amortization, operating expenses of $30,000 and depreciation expense of $25,000. The adjusted tax basis at year end is:

$120,000 The beginning basis is $125,000 ($75,000 cash contribution plus $50,000 recourse note). The income of $50,000 increases the basis to $175,000. The total losses of $70,000 ($15,000 of interest; $30,000 of operating expenses; and $25,000 of depreciation) then reduce the basis to $105,000. The principal paydown of the loan reduces the basis by another $5,000 to $100,000.

A customer buys an oil and gas limited partnership interest for $20,000 and signs a $10,000 recourse note. After the first year of operations, the investor's K-1 shows: Revenue $30,000 Operating Expenses$17,000 Debt Service - consisting of $5,000 principal repayment and $3,000 interest$ 8,000 Management Fees$ 5,000 Depreciation$ 2,500 Percentage Depletion$ 4,500 The investor has net taxable income or loss for this year of:

$2,000 loss The income statement for this year will show: Revenues$30,000 Less: Operating Expense$17,000 Interest Expense$ 3,000 Management Fees$ 5,000 Depreciation$ 2,500 Percentage Depletion$ 4,500 Net Loss($ 2,000) Notice that principal repayments, which are not income statement items, are not included. These will be used to adjust the basis at year end, however, since a repayment of recourse debt reduces the basis.

A customer buys an oil and gas limited partnership interest by contributing $20,000 and signing a $20,000 non-recourse note. The customer's tax basis is:

$20,000 Investors are not at risk for non-recourse financing so it is excluded from the basis (with the exception of real estate programs which are exempt from the at risk rule). Only the $20,000 cash contribution is included in the basis, so potential tax deductions are reduced.

A customer buys an oil and gas limited partnership interest for $20,000 and signs a $10,000 recourse note. After the first year of operations, the investor's K-1 shows: Revenue $30,000 Operating Expenses $17,000 Debt Service - consisting of $5,000 principal repayment and $3,000 interest$ 8,000 Management Fees $ 5,000 Depreciation $ 2,500 Percentage Depletion $ 4,500 The investor's adjusted tax basis at year end is:

$23,000 The adjusted basis at year end is computed as follows: Beginning Basis. Cash Contribution $20,000 Recourse Note + $10,000 Beginning Basis = $30,000 Debt Repayment. - $ 5,000 Adjusted Basis = $25,000 Net Loss From Operations -$ 2,000 Adjusted Basis at Year End =$23,000 *The net loss from operations is the revenue of $30,000, minus $17,000 of operating expenses, $3,000 of interest expense, $5,000 of management fees, $2,500 of depreciation and $4,500 of depletion.

A customer buys an oil and gas limited partnership interest for $100,000 and signs a $30,000 recourse note. After the first year of operations, the investor's K-1 shows: Revenue$75,000 Operating Expenses$45,000 Debt Service - consisting of $5,000 principal repayment and $15,000 interest. $20,000 Management Fees$10,000 Depreciation$ 7,000 Percentage Depletion$ 3,000 The investor has net taxable income or loss for this year of:

$5,000 loss The income statement for this year will show: Revenue$75,000 Less:Operating Expenses$45,000 Debt Service - Interest Expense Only $15,000 Management Fees$10,000 Depreciation$ 7,000 Percentage Depletion$ 3,000 Net Loss($ 5,000) Notice that principal repayments, which are not income statement items, are not included. These will be used to adjust the basis at year end, however, since a repayment of recourse debt reduces the basis.

A customer subscribes to a $50,000 limited partnership interest. The commission is $5,000. The up-front costs are $2,500 for legal expenditures, and $2,500 for organization costs. What is the customer's beginning tax basis?

$50,000 The beginning partnership basis for tax purposes consists of all dollars paid to the partnership ($50,000). The commissions, legal fees, and accounting fees are all included in the $50,000 price and are an integral part of the beginning basis. There are no "up front" deductions for these costs. Adjustments to the beginning basis will occur after the partnership's first year of operations. At that point, a K-1 is issued, showing that partner's share of partnership income and loss; and any cash distributions made by the partnership or additional cash contributions made to the partnership; and the assumption or repayment of any recourse debt of the partnership. All of these items are netted against the beginning basis to arrive at the year-end "adjusted basis."

A customer invests $50,000 in a real estate limited partnership. In the first year of operations, the investor is allocated $10,000 of income; $20,000 of interest deductions; $35,000 of operating expenses; and $7,000 of depreciation expense. Assuming that the investor has sufficient passive income, this investor may deduct a net loss of how much from his tax return for this year?

$50,000 The partnership's net loss from operations for this year is: Income:$10,000 Expenses:Interest$20,000 Operating$35,000 Deprec.$ 7,000 Net Loss$52,000 Since the beginning basis was $50,000, only this amount may be deducted for this tax year. The remaining $2,000 of unused losses are carried over to the next tax year and may be deducted if the basis increases to at least this amount during that year.

An investor contributes $400,000 of cash to a partnership and signs a $200,000 recourse note. During the first year, the investor is allocated partnership income of $250,000, debt service expense of $150,000 consisting of $105,000 of interest and $45,000 of principal amortization, operating expenses of $25,000 and depreciation expense of $125,000. The "net cash flow" from operations for the year is:

$75,000 Net cash flow from operations is income minus all cash costs. Depreciation is not cash, so it is excluded. $250,000 income minus $150,000 debt service expense and $25,000 operating expenses = $75,000 cash flow.

A customer invests $200,000 in a limited partnership and signs a recourse note for $100,000. In the first year, the investor's K-1 shows: Income$100,000 Debt Service - consisting of $10,000 principal repayment and $20,000 interest$ 30,000 Operating Expenses$ 40,000 Depreciation$ 50,000 Management Fees$ 10,000 The net cash flow is:

+$20,000 Cash flow is defined as Net Income or Loss adjusted for non cash deductions such as depreciation and non-deductible cash outlays such as loan repayments.The reported net income or loss for the investor that year is computed as follows: Income:$100,000 Interest Expense-20,000 Operating Expense-40,000 Management Fee-10,000 Depreciation-50,000 Net Loss-20,000 Starting with a Net Loss of $20,000, add back $50,000 of depreciation to arrive at $30,000 of cash flow. However, $10,000 was paid down on the loan (principal repayment), so true net cash flow is +$20,000.

A tax shelter that invests in raw land offers which benefit?

Appreciation Raw land is neither depreciable nor depletable. Nor are tax credits allowed on raw land purchases. The only reason to buy and hold raw land is for appreciation potential.

Which of the following will increase the tax basis of a limited partnership interest? I Cash contribution II Cash distribution III Distributive share of partnership income IV Distributive share of partnership loss

I and III The "basis" is the theoretical value of the investment in the partnership. The "basis" amount establishes the limit of tax deductions that may be taken by the partner - so the larger the basis, the better it is for the partner.Cash contributions and assumption of debt will increase the basis (more money going into the partnership investment). In addition, each partner's "distributive" share of income increases the basis (this is income that is retained in the partnership that has not physically been sent to the partner).Cash distributions and pay down of debt by the partnership reduce the basis (this is cash being paid out of the partnership). In addition, each partner's "distributive" share of losses decreases the basis (these are losses that are retained in the partnership that have not physically been sent to the partner).

The Internal Rate of Return: I considers the time value of money II does not consider the time value of money III represents the implicit rate of return that a limited partnership is expected to yield to the partners IV represents the rate at which the partnership is expected to return cash to the partners

I and III The evaluation method used for direct participation programs that considers the time value of money is the "Internal Rate of Return" (IRR). This method finds the implicit interest rate that discounts the projected cash flows from the program to a present value of "0." This interest rate represents the implicit rate of return that the program is expected to return. Internal Rate of Return does not measure the rate at which cash is returned to the partners, since partnership cash flows may either be retained in the partnership; or may be distributed to the partners; at the discretion of the general partner.

In a Real Estate Limited Partnership, the general partner refinances an existing $5,000,000 mortgage on a $10,000,000 property to the original amount of $8,000,000. The interest rate on both mortgages is the same. Given that information, which of the following statements are TRUE? I Interest deductions to the limited partners will be increased II Interest deductions to the limited partners will remain the same III The partnership tax basis will be increased IV The partnership tax basis will remain the same

I and III The general partner is increasing the mortgage on the property to increase interest deductions to the limited partners (since the new loan is for a larger amount at the same interest rate). The partnership basis is increased by the assumption of either recourse or non-recourse debt in a real estate limited partnership. This transaction will not increase operating cash flow. Cash flow from operations will actually decrease due to the higher interest expense. However, the partnership will have an additional $3,000,000 of cash ($8,000,000 new mortgage vs. $5,000,000 old mortgage), to either invest or to make cash distributions to the limited partners.

Regarding an investor's basis in a limited partnership investment which of the following statements are TRUE? I Recourse financing is included in the tax basis II Non-recourse financing is included in the tax basis III The investor is "at risk" for any recourse financing IV The investor is "at risk" for any non-recourse financing

I and III Under the "at risk rule," only amounts for which an investor is personally at risk can be included in the basis. An investor is personally liable and "at risk" for any recourse financing. (The lender has recourse to the investor personally to repay the loan). Non-recourse financing is not included in the basis, since the investor is not personally "at risk" for this (with one major exception, non-recourse financing (e.g., a mortgage) is allowed to be included in the basis for real estate investments).

Limited partner rights include the right to: I inspect partnership books and records II establish the management fee paid to the general partner III sue the general partner for damages IV all assets upon dissolution of the partnership

I and III only The limited partner has the right to inspect the partnership books and records, and can sue the general partner. The management fee is not set by the limited partners; it is set by the general partner and is disclosed in the offering materials. If the investor thinks they are excessive, then he should not buy the program. Limited partners and general partners have rights to partnership assets upon dissolution, just as both LPs and GPs share partnership income and loss. However, their claim to partnership assets comes after secured and general creditors are paid.

Which of the following corporate characteristics are NOT considered by the IRS in determining the tax status of a limited partnership? I Business Intent II Free Transferability of Shares III Association of Owners IV Limited Liability

I and III only There are 4 corporate characteristics that the IRS assesses to determine if a business is to be taxed as a partnership. These are: Continuity of Life; Free Transferability of Shares; Limited Liability; Centralized Management. If a partnership has 3 or 4 of these characteristics, it will be taxed as a corporation; if it has 2 or less, it will be taxed as a partnership. There are 2 other corporate characteristics that the IRS does not examine. These are: Business Intent; and Association of Owners.

Which of the following will decrease the tax basis of a limited partnership interest? I Distributive share of partnership losses II Cash distribution from the partnership III Principal repayment of recourse debt by the partnership IV Assumption of recourse debt by the partner

I, II, III The "basis" is the theoretical value of the investment in the partnership. The "basis" amount establishes the limit of tax deductions that may be taken by the partner - so the larger the basis, the better it is for the partner.Cash contributions and assumption of debt will increase the basis (more money going into the partnership investment). In addition, each partner's "distributive" share of income increases the basis (this is income that is retained in the partnership that has not physically been sent to the partner).Cash distributions and pay down of debt by the partnership reduce the basis (this is cash being paid out of the partnership). In addition, each partner's "distributive" share of losses decreases the basis (these are losses that are retained in the partnership that have not physically been sent to the partner).

Which of the following are tax preference items included in the Alternative Minimum Tax? I Excess depreciation II Excess depletion III Excess intangible drilling costs IV Private purpose municipal interest income

I, II, III, IV All of the items listed are "tax preference" items for the Alternative Minimum Tax (AMT) calculation - excess depreciation deductions above straight line; excess intangible drilling cost deductions (IDCs); excess depletion deductions; and non-essential use private purpose municipal interest income.

Which of the following are "front end" fees that are deducted from the gross investment made in a limited partnership? I Legal and accounting fees II Organization costs III Cost of selling partnership units IV Operating costs

I, II, and III The "up-front" costs that are incurred in a limited partnership are the selling fees; organization costs; and legal and accounting expenses for establishing the partnership. For example, assume a prospectus for a $10,000 partnership interest shows the following: $10,000Unit$ 1,000Selling Expenses$ 500Organizational Costs$ 500Legal and Accounting Costs$ 8,000Net Proceeds Invested in Partnership Assets Of the $10,000 invested, $2,000 of expenses were incurred to establish the partnership, while only $8,000 was invested productively. Please note that these items are not deductible for tax purposes from the partner's income as an expense. Rather, they are incorporated into the beginning partnership basis. Any operating expenses incurred during that year would be deductible at the end of the year against the beginning basis. They are not an "up-front" cost.

Regarding a functional allocation oil and gas sharing arrangement, which of the following statements are TRUE? I The General Partner bears the intangible drilling costs II The Limited Partner bears the intangible drilling costs III The General Partner bears the tangible costs IV The Limited Partner bears the tangible costs

II and III In a functional allocation oil and gas sharing arrangement, the limited partners get the intangible drilling cost deductions (100% deductible in the year drilling occurs) while the general partner bears the costs that are not immediately deductible (tangible costs).

In an oil and gas income program, there: I is a high level of intangible drilling costs II are no intangible drilling costs III is a high level of depletion deductions IV are no depletion deductions

II and III In an income program, proven reserves in the ground are purchased. No drilling is required - this work is already complete. All that is left to be done is to extract the oil from the ground and sell it. As the oil is sold, the percentage depletion allowance shelters income from taxation.

A customer owns a real estate limited partnership interest, with an adjusted cost basis of $25,000. This interest has generated unused passive losses totaling $15,000. The partnership interest is sold for $25,000. Regarding the cost basis and capital gain or loss which of the following statements are TRUE? I The adjusted cost basis is $10,000 II The adjusted cost basis is $40,000 III The customer has a capital gain of $10,000 IV The customer has a capital loss of $15,000

II and IV The tax treatment of unused passive losses when a partnership interest is sold, is to add them to the cost basis. In this example, the customer has a partnership basis of $25,000 and $15,000 of unused passive losses, for an adjusted cost basis of $40,000. Since the sale proceeds from disposing of the partnership interest are $25,000, the customer has a capital loss of $15,000 on this investment for tax purposes. The end result is that the unused passive loss is converted into a capital loss when the partnership unit is sold.

Regarding investments in limited partnerships, which of the following statements are TRUE? I Net taxable gain or loss is computed at the limited partnership level II Net taxable gain or loss is computed at the individual partner's level III The partnership is a taxable entity IV The partnership is not a taxable entity

II and IV Partnerships are not taxable entities; all items of income and loss "flow through" to the tax returns of the partners. Tax liability only exists at the partner level - not at the partnership level.

Which of the following statements are TRUE regarding the tax status of limited partnerships? I Partnerships are taxable entities II Partnerships are not taxable entities III Tax liability exists at the partnership level IV Tax liability exists at the partner level

II and IV Partnerships are not taxable entities; all items of income and loss "flow through" to the tax returns of the partners. Tax liability only exists at the partner level - not at the partnership level.

Interest income from which of the following municipal issues would likely be included as a tax preference item in the Alternative Minimum Tax computation? I School District Bond II Industrial Revenue Bond III Public Housing Bond IV Redevelopment Bond

II and IV The interest income from non-essential private use municipal bond issues is included as a "tax preference" item in the Alternative Minimum Tax. Both School District Bonds and Public Housing bonds are considered to be "essential public uses" and are not subject to AMT. Industrial Revenue Bond issues are used to finance construction of plants for corporate lessors and are "private use." Redevelopment bond issues are used to finance rehabilitation of plant and offices, typically for corporate use, and also are considered to be "private purpose."

Which of the following corporate characteristics are considered by the IRS in determining the tax status of a limited partnership? I Business Intent II Free Transferability of Shares III Association of Owners IV Limited Liability

II and IV only There are 4 corporate characteristics that the IRS assesses to determine if a business is to be taxed as a partnership. These are: Continuity of Life; Free Transferability of Shares; Limited Liability; Centralized Management. If a partnership has 3 or 4 of these characteristics, it will be taxed as a corporation; if it has 2 or less, it will be taxed as a partnership. There are 2 other corporate characteristics that the IRS does not examine. These are: Business Intent; and Association of Owners.

When evaluating an investment in a direct participation program, which of the following are relevant considerations? I Experience of the limited partner(s) II Objectives of the program III Economic viability of the business venture IV Experience of the general partner(s)

II, III, IV Limited partners are passive investors who have no say in the management of the enterprise. Thus, experience of the limiteds has no relevance to the success of the program. General partners, however, manage the program for the limiteds. Their level of experience and "track record" is critical when evaluating the likely success of a program. Any evaluation should consider the objectives and economic prospects of the program.

Which type of Oil and Gas Program is the most conservative?

Income (Production) Exploratory oil and gas programs drill in virgin, uncharted areas. They have the highest level of risk; and the highest potential return. Developmental programs drill near existing fields. Since there is oil nearby, the chances of striking oil are better, and so the mineral rights cost is much higher than with an exploratory program. Thus, the level of risk and potential return is lower than that for an exploratory program. An income or production program buys an existing oil well with proven reserves, with the intention of stripping the remaining oil from the ground, partially sheltered by the depletion deduction. This program has the lowest level of risk and potential return. Finally, a combination program invests in all 3 types and, thus, would be riskier than a simple production (income) program.

The principal benefit of an oil and gas "drilling" program is:

Intangible Drilling Costs In an oil and gas "drilling" program, a drilling contractor is hired to drill for oil. The cost of the drilling ("IDC's") is 100% deductible as drilled. This is a tax benefit given by the Government to encourage drilling and is the main tax benefit of an oil and gas drilling program.

All of the following are depletable EXCEPT:

Machinery Only natural resources, such as coal, timber, oil, gas, gravel, etc., are depletable. Machinery and real estate are depreciable assets.

The responsibility for investigating the adequacy and accuracy of information contained in limited partnership offering materials rests with the:

Managing underwriter While offering materials are prepared by the issuer, the underwriter is obligated to perform due diligence as to the disclosures in those materials under the Securities Act of 1933. If there are any omissions or misstatements of material fact, and the underwriters did not perform due diligence, then they are liable for fraud.

Where would an investor in a private placement direct participation program find the cash flow projections over the program's life?

Offering memorandum The Offering Memorandum is the disclosure document that is given to potential investors in a private placement direct participation program. Another name is the Private Placement Memorandum. Note that if the offering were registered with the SEC, then the disclosure document would be the prospectus. The offering memorandum describes the business of the partnership, the management of the partnership, the assets to be purchased by the partnership, the minimum investment amount, fees paid to the underwriter, etc. It also includes an important section that gives a projection of the revenues and expenses, along with the annual cash flow, that the partnership expects to generate. This is evaluated to find the "cross-over" point in the partnership - the point where the partnership "crosses over" from generating losses to actually generating income.

All of the following are types of direct participation programs EXCEPT:

Real Estate Investment Trust Real Estate Investment Trusts are not Direct Participation Programs. These are stock companies, similar to closed end investment companies, which invest in real estate, short term construction, and mortgages. As a stock company, they do not allow for flow through of gain and loss. Direct participation program types include oil drilling programs; agricultural production; and equipment leasing programs. When set up as partnerships, these ventures allow the partners to directly share in income and loss.

Which statement is TRUE regarding limited partnerships?

The General Partner has the right to charge a management fee The general partner is the key executive; makes management decisions such as deciding which properties to buy and sell; and either manages the program or oversees a manager. The general partner (GP) collects a management fee for these duties and assumes unlimited liability. The GP can contribute capital to the venture, and typically does, because then potential investors (LPs) know that the GP has "skin in the game." The LP always has the right to vote. Because partnerships are illiquid securities, over the years, many partnerships changed their structure to become liquid. The LPs voted to contribute their LP units to what is called an "MLP" - a Master Limited Partnership. These are partnerships that are listed on an exchange and trade like any other stock. These are called partnership roll-up transactions because the LP units were "rolled-up" into a Master Limited Partnership.

If the alternative minimum tax computation is greater than the regular income tax computation, which statement is TRUE?

The alternative amount is due Under the tax law, each tax filer must compute both the regular income tax and the alternative minimum tax (known as the "tax on tax preferences"), and must pay the higher amount.

A customer invests $20,000 in a real estate program and signs a $30,000 non-recourse note. Which statement is TRUE?

The beginning tax basis is $50,000 Normally, financing for which investors are not at risk (non-recourse financing), is excluded from the basis. However, real estate programs are exempt from the at risk rule. Thus, the $20,000 cash contribution and the $30,000 non-recourse note are included in the beginning basis for a real estate program.

For an investor seeking a tax sheltered investment, the primary advantage of a real estate direct participation program is the:

ability of the program to generate losses for tax purposes but provide positive cash flow Limited partnership interests are not liquid. To avoid the corporate characteristic of "free transferability of shares," most partnership agreements place restrictions on transfer. The ideal structure for a partnership is to generate losses for tax purposes (in a real estate program, through mortgage interest and depreciation deductions), yet show positive cash flow (since depreciation is a "paper" write-off). Since real estate is considered a passive investment, any losses can only be offset against passive income - not earned income. The structure of partnerships generates higher losses in the early years, and lower losses in the later years. This gives people with "tax problems" the incentive to buy such a program, since the deductions are "front loaded," and the potential purchaser needs those deductions today.

When an investor disposes of an interest in a limited partnership, the taxable gain or loss is the difference between the sale proceeds and the:

adjusted cost basis The formula for determining the amount of capital gain for all investments is: capital gain/loss = sale proceeds - adjusted cost basis

When comparing real estate limited partnerships (RELPs) to real estate investment trusts (REITs), all of the following statements are true EXCEPT that both:

allow for flow-through of loss to investors Both real estate limited partnerships and real estate investment trusts invest in real estate and have centralized management. In a partnership, management is performed by the general partner. REITs have a Board of Trustees that oversee operating management. Only real estate limited partnerships (RELPs) have "partners" - REITs issue stock. Only RELPs can pass through losses to the partners; REITs cannot. Both real estate limited partnerships and real estate investment trusts can pass through gains to partners and shareholders, respectively. REITs can do so under the conduit tax treatment afforded under Subchapter M of the Internal Revenue Code.

All of the following will decrease the tax basis of a limited partnership interest EXCEPT:

distributive share of partnership income The "basis" is the theoretical value of the investment in the partnership. The "basis" amount establishes the limit of tax deductions that may be taken by the partner - so the larger the basis, the better it is for the partner.Cash contributions and assumption of debt will increase the basis (more money going into the partnership investment). In addition, each partner's "distributive" share of income increases the basis (this is income that is retained in the partnership that has not physically been sent to the partner).Cash distributions and pay down of debt by the partnership reduce the basis (this is cash being paid out of the partnership). In addition, each partner's "distributive" share of losses decreases the basis (these are losses that are retained in the partnership that have not physically been sent to the partner).

A developmental oil and gas limited partnership program would:

drill a new well near an existing oil field Developmental programs drill "step-out" wells. The name comes from "stepping out" from an existing field to drill in an adjacent area. In contrast, income programs buy existing older wells and increase output by injecting water, steam, and chemicals into the ground to bring up the remaining oil. Exploratory programs drill "wildcat" wells in unproven areas.

When evaluating an investment in a direct participation program, all of the following are relevant considerations EXCEPT:

experience of the limited partner(s) Limited partners are passive investors who have no say in the management of the enterprise. Thus, experience of the limiteds has no relevance to the success of the program. General partners, however, manage the program for the limiteds. Their level of experience and "track record" is critical when evaluating the likely success of a program. Any evaluation should consider the objectives and economic prospects of the program.

An oil and gas program that provides high initial deductions and low mineral rights cost would be a(n):

exploratory program In an exploratory program, "wildcat" wells are drilled in unproven areas. Because the odds are finding oil are low, the mineral rights cost is low. As with all drilling programs, the IDCs (intangible drilling costs - basically the cost of drilling holes!) are 100% deductible as drilled, so there are large up-front deductions. These are high risk, high return programs.

The advantage of a limited partnership business structure as opposed to a corporate business structure is:

flow-through of gain and loss The advantage of the partnership form of business is that the partnership itself is not a taxable entity; income and loss from the partnership "flows-through" onto the individual partners' tax returns. Thus, any net income is taxed once; and any net loss is included on the partner's tax return. In contrast, a corporation must compute net income or loss at the corporate level; and must pay tax on any income. The only way for the shareholder to receive a portion of the net income is for the corporation to pay a dividend, which must be included on the shareholder's tax return; and which is taxed again! Any net losses remain at the corporate level - they cannot be distributed to shareholders. Both corporations and limited partnerships have centralized management; and both shareholders and limited partners have limited liability. Partnerships have a higher risk of audit than corporations, making this a real disadvantage to the partnership form of business.