S7 UNIT 10 Quizzes (Other Packaged Products)
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) $10,000 C) $33,000 D) $100,000
A) $0 Explanation 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. LO 10.b
An investor in a limited partnership generating passive losses can offset these against I) passive income from other partnerships. II) rental income from direct investments in real estate. III) dividends received from listed securities. IV) capital gains from the sale of unlisted securities. A) I and II B) III and IV C) II and III D) I and III
A) I and II Explanation Passive losses can be deducted from passive income and income from certain real estate investments; it cannot be deducted from active or portfolio (investment) income. LO 10.e
Which of the following statements regarding oil and gas limited partnerships are true? I) Developmental programs are more risky than exploratory programs. II) Exploratory programs are more risky than developmental programs. III) Successful developmental programs provide higher returns than exploratory programs. IV) Successful exploratory programs provide higher returns than developmental programs. A) II and IV B) I and IV C) I and III D) II and III
A) II and IV Explanation Exploratory oil and gas direct participation programs drill in areas where there are no proven oil reserves. While the chances of success are relatively small, successful exploratory wells provide large returns to investors. Developmental programs drill in areas adjacent to sites where proven oil reserves exist; while the probability of success is favorable, the returns will not be as great as a successful exploratory program. LO 10.d
Some limited partnership programs provide potential tax credits to partners. Which of the following typically provide potential tax credits? I) Rehabilitation of historic properties II) Equipment leasing III) Developmental oil and gas programs IV) Government-assisted housing programs A) II and III B) I and IV C) III and IV D) I and II
B) I and IV Explanation Historic rehabilitation and government-assisted housing are two programs that offer potential tax credits. Tax credits are no longer available for equipment leasing, and while developmental oil and gas programs offer high intangible drilling costs, these are not investment tax credits. LO 10.d
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) Business risk B) Liquidity risk C) Default risk D) Interest rate risk
B) Liquidity risk Explanation 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. LO 10.a
An investor in an equipment-leasing direct participation program (DPP) using straight-line depreciation would probably not be concerned about A) legislative risk. B) the likelihood of recapture. C) liquidity risk. D) the quality of the management.
B) the likelihood of recapture. Explanation 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. LO 10.f
A sharing arrangement in which only deductible costs are apportioned to the investor, with the sponsor bearing all capitalized costs is called A) a reversionary sharing arrangement. B) a carried interest. C) a functional allocation. D) an overriding royalty arrangement.
C) a functional allocation. Explanation Functional allocation is a sharing arrangement in which the general partner pays for all tangible drilling costs (capitalized costs), and the limited partners pay for all intangible drilling costs (deductible costs). LO 10.e
When analyzing a direct participation program investment, a method that takes into account the revenues and expenses is A) liquidity analysis. B) fundamental analysis. C) cash flow analysis. D) technical analysis.
C) cash flow analysis. Explanation Revenues and expenses are cash items and would be analyzed by cash flow analysis. LO 10.f
All of the following statements regarding the risks of investing in an oil and gas limited partnership are true except A) income programs have fewer tax benefits than exploratory programs. B) wells may not have sufficient reserves to return drilling costs. C) development programs have higher risk than exploratory programs. D) development programs may involve acquisition of expensive leases
C) development programs have higher risk than exploratory programs. Explanation Exploratory programs have the highest risks, rewards, and tax benefits. Development wells are drilled to develop a reserve that is already known to be present. LO 10.d
Your firm is sponsoring an equipment leasing direct participation program. The program's goal is to raise $130 million. If the program is fully subscribed, FINRA rules would permit your firm to earn a maximum of A) $19.5 million. B) $11.05 million. C) $6.5 million. D) $13 million.
D) $13 million. Explanation FINRA Rule 2310 places limits on the overall expenses and amount of broker-dealer compensation considered fair and reasonable. That cannot exceed 10% of the gross proceeds. In this question, 10% of $130 million is $13 million. Do not confuse this 10% with the 15% maximum applying to organization and offering expenses. LO 10.g
A customer buys a real estate limited partnership interest by contributing $20,000 and signing a nonrecourse note for $50,000. The customer's beginning basis is A) $30,000. B) $20,000. C) $50,000. D) $70,000.
D) $70,000. Explanation Generally, nonrecourse debt does not add to basis because the limited partner is not responsible (at risk) for the repayment of the debt. However, in real estate partnerships, the at-risk rules do not apply, and therefore, add to basis in this type of partnership. LO 10.e
An investor with a large salary, as well as unearned investment income, is two years from retirement. If she wants to shelter a portion of her income, which of the following programs would provide her with substantial initial write-offs? A) Raw land B) An oil and gas income program C) Existing housing D) An oil and gas drilling program
D) An oil and gas drilling program Explanation Oil and gas drilling programs pass through intangible drillings costs, which the partners may use to reduce passive income. LO 10.e
If near-term liquidity were the only objective for a client, which of the following pairs of investments would represent the most/least liquid? A) Variable annuity/money market mutual funds B) Variable annuity/direct participation programs C) 10-year corporate bonds/U.S. T-bills D) Exchange-listed equities/direct participation program
D) Exchange-listed equities/direct participation program Explanation Of the pairings offered to choose from, exchange-listed equities are considered liquid, as they could be easily divested of, and direct participation programs, which all have predetermined (scheduled) end dates, would be the least liquid. LO 10.f
Which of the following registers the securities and packages the program for a limited partnership? A) Property manager B) General partner C) Limited partners D) Syndicator
D) Syndicator Explanation A syndicator handles the registration of the limited partnership units. LO 10.b
Which of the following documents would describe the roles of the general and limited partners in a limited partnership offering? A) The prospectus B) The certificate of limited partnership C) The subscription agreement D) The partnership agreement
D) The partnership agreement Explanation The partnership agreement describes the roles of the general partners (GPs) and the limited partners (LPs). The certificate of limited partnership is a document filed with the limited partnership's home state for legal recognition. The LPs complete the subscription agreement (essentially the request to purchase) disclosing important personal information. The most important is the financial information, such as income and net worth. The GPs use that in determining suitability. The subscription agreement is not effective, and the LPs are not accepted into the partnership, until it is signed by the GPs. The prospectus is a document that discloses all material facts regarding the investment to investors. Note that if the program is a private placement, in lieu of a prospectus, the investor receives a private placement memorandum containing essentially the same information. LO 10.b
The principal tax benefit of investing in an exploratory oil and gas drilling program is derived from A) capital appreciation. B) recapture. C) depreciation expenses. D) intangible drilling costs (IDCs).
D) intangible drilling costs (IDCs). Explanation IDCs, which are a significant portion of all drilling costs, are a major tax advantage to a limited partner and are tax deductible in the year in which they are incurred. IDCs are costs that, after incurred, hold no salvage or ongoing value. Examples include labor and geological survey. LO 10.e
A direct participation program (DPP) would not be structured as A) an LLC B) a C corporation C) an S corporation D) a limited partnership.
B) a C corporation Explanation Although most DPPs are structured as limited partnerships, they may also use the other business forms allowing flow-through of income and losses (s corporations and LLCs). Because the C corporation is a taxable entity, it is not used as the structure for a DPP. LO 10.b
The IRS will generally consider a direct participation program to be an abusive tax shelter unless the program can show a profit motive. A popular method of measuring the economic viability of a DPP is A) passive loss analysis. B) cash flow analysis. C) income to debt analysis. D) the ratio of gains to losses.
B) cash flow analysis. Explanation On the exam, there are two accepted measures of the economic viability of a DPP. Those are cash flow analysis and internal rate of return (IRR). Cash flow analysis compares the income to the expenses, not the debt. LO 10.f
An equipment-leasing DPP is capitalized with $10 million from the sale of 500 limited partnership units. After receiving a large order for leased equipment, the partnership must raise additional funding to make the acquisition. If the partnership obtains $20 million in recourse financing, the effect of this is A) each limited partner must contribute an additional $40,000. B) each limited partnership unit has a basis of $60,000. C) the general partners are liable for the $20 million of additional financing. D) each limited partnership unit has a basis of $20,000.
B) each limited partnership unit has a basis of $60,000. Explanation Each limited partnership unit had an original cost basis of $20,000 ($10 million divided by 500 units). Recourse financing adds to the investor's basis. That represents an additional $40,000 per unit making the total basis $60,000 for tax purposes. LO 10.e
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) equity REITs. B) preferred REITs. C) hybrid REITs. D) mortgage REITs.
B) preferred REITs. Explanation 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. LO 10.a
One of your customers invests $20,000 in an oil and gas limited partnership program. The Schedule K-1 she receives at year-end from the partnership indicates that operating revenues and operating expenses were exactly the same. In addition, her share of the year's depletion allowance is $6,000. During the year, she received a cash distribution of $8,000. What is her basis as of year-end? A) $12,000 B) $16,000 C) $6,000 D) $8,000
C) $6,000 Explanation She began with a basis of $20,000 (her original investment). During the year, she received a distribution of $8,000. That lowered her basis (the amount of money "at risk") to $12,000. In addition, the depletion represents a nonoperating expense that can be taken as a loss. That brings the basis down to $6,000. LO 10.e
Income from which of the following investments is passive income? I) Real estate direct participation programs (DPPs) II) Vacation cottage rentals III) Real estate investment trusts (REITs) IV) Collateralized mortgage obligations (CMOs) A) II and III B) II and IV C) I and II D) I and III
C) I and II Explanation Passive income results from DPPs and personal real estate rentals. REITs and CMOs are securities, and income from securities is considered portfolio income. LO 10.e
Which of the following best describes an intangible drilling cost? A) Tax liability B) Exploratory well drilling C) Labor, fuel, or drilling rig rental D) Proven reserve of oil or gas
C) Labor, fuel, or drilling rig rental Explanation 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. LO 10.e
All of the following documentation is necessary for a publicly subscribed limited partnership except A) a subscription agreement. B) a partnership agreement. C) a cash flow analysis. D) a certificate of limited partnership.
C) a cash flow analysis. Explanation The certificate gives public information about the partnership and is filed in the home state. The partnership agreement spells out the roles of the general and limited partners. The subscription agreement is the instrument by which the limited partners invest. LO 10.b
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) developmental. C) functional allocation. D) exploratory
C) functional allocation. Explanation 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. LO 10.d
In a direct participation program, a general partner is all of the following except A) one who buys and sells the program's property. B) a key executive who makes day-to-day business decisions. C) one who has limited liability. D) one who appoints the property manager.
C) one who has limited liability. Explanation A general partner of a limited partnership is a key executive of the program who purchases and sells the property and/or appoints someone to manage the property. The general partner does not have limited liability. By not allowing the general partner to have limited liability, the program is able to rule out limited liability as a corporate characteristic. LO 10.c
The managing partner of a limited partnership has responsibility for all of the following except A) paying partnership's debts. B) managing the operations. C) providing unlimited capital for the partnership business. D) organizing the business.
C) providing unlimited capital for the partnership business. Explanation 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. LO 10.c
When a limited partnership terminates, a limited partner's gain or loss is determined by comparing A) the total losses to the total income. B) the final proceeds to the original cost basis. C) the final proceeds to the adjusted cost basis. D) the passive income to the passive losses.
C) the final proceeds to the adjusted cost basis. Explanation Just as with the sale or liquidation of any asset, a gain or loss is determined by comparing the proceeds to the cost. In the case of a DPP, it is the adjusted cost basis that is used. LO 10.e
A FINRA member firm wishes to encourage its registered representatives to sell more limited partnership DPPs. As an incentive, the firm offers an all-expenses-paid trip to a popular vacation resort for those reaching certain sales targets. FINRA rules provide that A) the target must be based on the total production of associated persons with respect to specific investment company securities distributed by the member. B) the member can weight the credits differently for different investment companies. C) the target must be based on the total production of associated persons with respect to all direct participation programs offered by the member. D) sales incentives are limited to gifts that do not exceed $100 in value.
C) the target must be based on the total production of associated persons with respect to all direct participation programs offered by the member. Explanation FINRA made a slight modification to its rules on noncash compensation because of the SEC's Regulation BI (best interest). Specifically, if there is to be any kind of sales contest or other method of incentivizing registered representatives, sales of the particular product type must give equal weighting to all of those investments sold by the firm. This applies largely, but not exclusively, to sales of investment companies, variable products of life insurance companies, and direct participation programs. Previously, firms could give higher weighting to sales of proprietary products, but that ended on June 30, 2020. LO 10.g
The IRS determined that the NYCOSSET real estate existing property limited partnership is abusive. The most likely reason would be that A) each partner received enough in losses to shelter all income. B) all of the assets were found to be rental properties. C) there was no viable profit motive. D) no net profit was generated after losses were taken.
C) there was no viable profit motive. Explanation To qualify as a limited partnership direct participation program (DPP), above all else, there must be a viable chance to make a profit. Any DPP established without a profit motive or with the intention of only generating tax losses for investors may be determined abusive by the IRS subjecting the partners to penalties including prosecution for fraud. LO 10.e
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) Net operating profits interest B) Carried interest C) Overriding royalty interest D) Functional allocation
D) Functional allocation Explanation 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. LO 10.e
When conducting a discussion with a client about the merits of investing in a direct participation program, all of the following could be tax advantages except I) accelerated depreciation. II) depletion allowances. III) recapture of depreciation. IV) tangible drilling expenses. A) I and II B) II and III C) I and IV D) III and IV
D) III and IV Explanation Depreciation is the deduction against income representing the cost recovery of certain fixed assets. When one of those assets is sold for more than the straight-line depreciated value, the excess is recaptured as ordinary income. Only intangible drilling expenses benefit the limited partner. LO 10.f
Client invests $100,000 into a real estate limited partnership (RELP). During the first three years, the partnership makes no distributions. The Schedule K-1s received over that period total passive losses of $50,000. The client then invests $75,000 into an exploratory oil and gas DPP. Six months later, the program strikes the largest pool of oil in the United States. The K-1 for that partnership declares $500,000 income. Which statement is true? B) The $50,000 may be claimed, but because it was generated over a three-year period, one-third of the amount may be used for the three forward years. C) The carryover loss can be added to the $75,000 cost basis of the new program, with the difference between the $500,000 income and the $125,000 cost being treated as capital gain. D) Passive losses may be carried over indefinitely, so the $50,000 can be used to offset the passive income generated by the new program.
D) Passive losses may be carried over indefinitely, so the $50,000 can be used to offset the passive income generated by the new program. Explanation This is an example of a question that contains far more information than is necessary. The simple answer is that passive losses may be used against passive income. There is no time limitation—there just has to be passive income. LO 10.e
Which of the following statements regarding real estate investment trusts (REITs) is not correct? A) REITs pool capital in a manner similar to an investment company. B) REITs offer professional management and diversification. C) REITs manage portfolios of real estate investments to earn profits and/or income. D) REITs are typically not publicly traded.
D) REITs are typically not publicly traded. Explanation 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. LO 10.a
An individual who invests in an undeveloped land limited partnership would be most interested in A) operating expense deductions. B) depletion. C) depreciation. D) appreciation.
D) appreciation. Explanation Investors seek appreciation when investing in undeveloped land limited partnerships. LO 10.d
One of the key requirements in offering a DPP to a customer is that the program must be suitable. FINRA has some specific suitability requirements for DPPs. Among those is the investor A) does not own a DPP that will compete with the program being offered. B) has sufficient net worth to be deemed an accredited investor. C) has sufficient experience in the type of business the program is undertaking. D) has a net worth sufficient to sustain the risks of the DPP, including loss of investment.
D) has a net worth sufficient to sustain the risks of the DPP, including loss of investment Explanation FINRA's Rule 2310 lists a few suitability standards necessary for recommending DPPs. Among those is the need for the investor to have a net worth sufficient to sustain the risks of the DPP, including loss of the investment. Although many DPPs, but not all, are limited to accredited investors, that is not a FINRA suitability standard; that is an SEC requirement. It is the general partner who cannot be in a business that competes with the DPP. LO 10.g
Among the differences between a real estate investment trust (REIT) and a real estate limited partnership investment (a DPP) is that A) the DPP takes an ownership interest in the property, while the REIT only makes mortgage loans. B) the DPP generally has more investors than the REIT. C) REITs generally trade on the listed exchanges, while DPPs actively trade OTC. D) only the DPP is a flow-through vehicle.
D) only the DPP is a flow-through vehicle. Explanation DPPs are the investment vehicle providing flow-through of income and loss. REITs are required to return at least 90% of their net investment income to investors, but losses do not pass through. Both investments can take equity or debt positions. They can also be hybrid and take both. Because DPPs are almost always private placements, the number of investors is usually small. On the other hand, because most REITs are publicly traded, they can have a large number of investors. As private placements, there is no active secondary market for DPPs. LO 10.e
