Unit 10: Other Packaged Products

REIT Taxation

- A REIT shareholder is generally taxed only on dividends paid by the REIT and on gains upon the disposition of REIT shares. - A REIT is a corporation for US tax purposes. But is generally not subject to corporate tax if it distributes to its shareholders substantially all of its taxable income for each year. (Substantially = a REIT can avoid being taxed as a corporation by receiving 75% or more of its income from real estate and distributing 90% or more of its taxable income to its shareholders. - Shareholders receive dividends from investment income. Dividends are taxed at ordinary income rates rather than as qualified dividends. - If there are cap gains distributions, they are generally taxed at the favorable 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.

Important Points to Remember about REITS:

- An owner of REITs holds an undivided interest in a pool of real estate investments. - REITS are liquid because they trade on exchanges and OTC. - REITS are not investment companies (mutual funds). - REITs offer dividends and gains to investors but do not offer flow-through losses like limited partnerships and therefore are not considered direct participation programs (DPPs). - REITs are not DPPs (losses do not flow through). - A REIT must receive 75% or more of its income from real estate, have at least 75% of its assets in real estate and cash, and distribute 90% or more of its taxable income to its shareholders to avoid taxation as a corporation. - Dividends from REITS are not qualified, they are taxed as ordinary income.

FINRA Rule 2310 discusses...

- DPP Suitability - DPP Compensation Restrictions - Noncash Compensation - DPP Rollup

Three Types of REITs

- Equity REITs - Mortgage REITs - Hybrid REITs

Types of Oil and Gas Partnerships

- Exploratory (Wildcatting) - Developmental - Income

DPP Regulations

- FINRA Rules Dealing with DPPs - SEC Rules Dealing with DPPs

DPP Investor Disadvantages:

- Liquidity Risk: secondary market for DPPs is limited (hard to find buyers) - Legislative Risk: changes to tax laws can damage LPs - Leverage Risk: DPPs commonly use borrowed funds - Risk of Audit: Higher percentage of returns selected for audit by IRS - Depreciation Recapture: One of the tax benefits is the ability to depreciate most fixed assets, especially when that depreciation can be accelerated. Effect is to lower the tax basis of the asset.

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

Mortgage REITs

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

Benefits to Investors who purchase REITs include....

- 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 pros with greater negotiating power than an individual. - There is a negative correlation to the general stock market because real estate prices and the stock market frequently move in opposite directions. - There is reasonable income and/or potential capital appreciation

Types of Real Estate Partnerships

- Raw Land - New Construction - Existing Property - Government-Assisted Housing Programs - Historic Rehabilitation

Required Documentation for Limited Partnerships to Exist:

- The certificate of limited partnership - The partnership agreement - The subscription agreement

Risks to the Investors who purchase REITs include....

- The investor has no direct control over the portfolio and relies on professional management to make all purchase and sale decisions (quality of portfolio lies with the quality of the management). - REITS generally have greater price volatility than direct ownership of real estate because 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.

Equipment Leasing Programs

- 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, and depreciation. - Tax credits were once available through these programs but were discontinued by tax law changes. Primary investment objective is tax-sheltered income.

Evaluating DPPs

-Economically viable (potential for returns from cash distributions and capital gains) -Economic Soundness: 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. IRR you need to know it takes into consideration the time value of money and is a favorite method of evaluating a DPP. Other Evaluation Factors: - Management ability and experience if the GP - Blind pool or nonspecific program - Time frame of the partnership - Similarity of start-up costs and revenue projections to those of comparable ventures - Lack of liquidity of the interest

Oil and Gas Sharing Arrangements

-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 none 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 placements. -Disproportionate sharing: The BP bears a relatively small percentage of expenses but receives a relatively large percentage of the 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 partnership receives the IDCs, which allow immediate deductions. The GP receives the tangible drilling costs, which are depreciated over several years. Revenues are shared.

DPP Investor Advantages

-an investment managed by others -flow-through of income and certain expenses -limited liability

Types of DPPs

1-real state 2-oil and gas 3-equipment leasing programs

Real Estate Investment Trust (REIT)

A company that manages a portfolio of real estate investments in order to earn profits and/or income for its shareholders. - offer professional management and diversification - typically, publicly traded and serve as a source of long-term financing for real estate projects. - organized as trusts in which investors buy and sell shares either on stock exchanges or in the OTC market. - not redeemable to the issuer but have the liquidity of listed stocks (prices based on supply and demand). - Compute a NAV per unit but it's only an approximation (price can be more, less, or the same as NAV.

Subscription Agreement

All investors interested in becoming limited partners 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, and - a power of attorney appointing the GP as the agent of the partnership. In addition to a cash contribution, subscribers (LPs) 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 (not the LPs) have responsibility for repayment of nonrecourse loans. Only in real estate DPPs does the nonrecourse loan add to the investor's basis.

Packaged Product

An investment that relieves the investor of daily decision making like REITS and DPPs.

Tax Basis

An investor's tax basis represents the upper limit on deductibility of losses. LPs must keep track of their tax basis, or amount 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. Partners must adjust their basis at year-end. All the following below are reductions to a partner's basis. An LP's basis consists of: - cash contributions to the partnership - noncash property contributions to the partnership - recourse debt of the partnership, and - nonrecourse debt for real estate partnerships only.

A 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. It CANNOT just be a merely joint undertaking to share expenses like co-ownership of property maintained and rented or leased. The co-owners to be labeled a partnership must also provide services to the tenants.

FINRA Rules Dealing with DPPs

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

DPP Rollup

Combination of 1 or more LPs creating new partnership.

Partnership Agreement

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

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. Compare that to a home mortgage. The interest is deductible, but that portion of the mortgage payments applied to reduce the loan is not. Cost recovery systems offer write-offs over a period of years as defined by IRS schedules. Depreciation write-offs apply to cost recovery of expenditures for equipment and real estate. (Land cannot be depreciated.) Depletion allowances apply to the 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.

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 lenders - Other creditors - LPs (First, for their claims to shares of profits and second, for their claims to return of contributed capital) - GPs (First, for fees and other claims not involving profits, second, for a share of profits, and third, for capital return)

Noncash Compensation

Gifts cannot exceed $100 per year. An occasional meal or ticket to a sporting event would be permitted.

Oil and Gas Program Taxation

Intangible Drilling Costs: - 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. Intangible drilling costs (IDCs) can be defined as any cost that, after being incurred, has no salvage value. Tangible Drilling Costs: - Those costs incurred that have salvage value (e.g., 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. Two forms of depletion are cost and percentage.

Computing Tax Basis

Investment in partnership + share of recourse debt + nonrecourse debt in real estate DPPs - cash or distributions = basis *Note a sales charge doesn't change initial investment in a partnership

Direct Participation Programs (DPPs)

Investments that pass income, gains, losses, and tax benefits (such as depreciation, depletion, and tax credits) directly to the limited partners. - One of the most common types of DPPs are limited partnerships, but can also be set up as S corporations or Limited Liability Companies (LLCs)

DPP Taxation

It is important to understand that a DPP is just a different way to invest in a business rather than buying the company's stock. There are certain tax advantages to being structured as a partnership with the follow-through of income or loss being one of them. That aside, a DPP is merely an investment in a business. Important tax concepts associated with DPPs include the following: - DPPs were formerly known as tax shelters because 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 only passive income, not all ordinary income as before. Many programs lost their appeal because of this critical change in tax law. - Passive income is not considered earned income for the purpose of making an IRA contribution. - The IRS considers programs without economic viability to be abusive tax shelters. The promoters and investors can face severe penalties.

Tax Filing Requirements

Limited Partnerships do not file a formal tax return because of flow-through. An information return is filed on Form 1065 and due on March 15 of the following year. Business entity pays no income tax. The year-end for these businesses is typically December 31. Taxes are due on April 15 when individual partners file their Form 1040s.

Issuing Limited Partnership Interests

Limited partnerships can be sold through private placements 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. - In a public offering, partnerships are self with a prospectus to a larger number of investors, each making a relatively small capital contribution, such as $1,000 - $5,000. 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 finder's fees are limited to 10% of the gross dollar amount of securities sold.

SEC Rules Dealing with DPPs

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

Structuring a Limited Partnership

One of those 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 a corporation - 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. In other words, partnerships have a predetermined date of dissolution when they are established, whereas corporations are expected to exist in perpetuity. Interests cannot be freely transferrable.

Hybrid REITs

Own commercial property and own mortgages on commercial property. Combo of equity and mortgage REITs.

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.

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

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

Developmental

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

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)

Partnership Objective: Locate undiscovered reserves of oil and/or gas. Advantages: High rewards for discover of new reserves 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

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

Raw Land

Partnership Objective: Purchase undeveloped land for its appreciation potential. Advantages: Appreciation potential on 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

DPP Compensation Restrictions

Rule places limits on overall expenses and amount of B/D compensation considered fair and reasonable: - If 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 pross proceeds. included in the 10% is any compensation to the wholesaler.

Certificate of Limited Partnership

The document that must be filed in the home state of the partnership. It must include: - the partnership's name - the partnerships 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 LP's current and future expected investment - the contribution return date, if set, - the share of profits or other compensation to each LP - the conditions for each LP's assignment of ownership interests - whether the limited partnership may admit other LPs, and - whether the business can be continued by remaining GPs at death or incapacity of a GP.

Flow Through

The key benefit of DPPs is that they allow the economic consequences of a business to follow-through to investors. Any income or loss to the investor is considered passive because 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. Although each of the DPPs covered offer flow-through, some of the details are unique to each program.

Real Estate Program Taxation

The tax benefit from all DPPs is those operating losses flow-through to investors. when a corporation loses money, there is no tax benefit to shareholders. 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 expenses - depreciation allowances for the wearing out of the building, and - expenses for improvement to 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. Ex: tax deduction of $1,000 for an individual in the 30% tax bracket means she saves $300 in tax. a $1,000 tax credit means she lowers her taxes by $1,000.

DPP Suitability

customer must be: - in a position to take full advantage of any tax benefits generated by the DPP, and - has a net worth sufficient to sustain the risks of the DPP, including loss of investment.