Unit 11 Series 7
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?
$0 The limited partner will not receive any return of his investment. In a failed program, the partnership's creditors are paid first with any sale proceeds—before the limited partners receive any money. Because the limited partners had not signed a recourse agreement, even though the partnership still owes $2 million on the mortgage, the limited partners are not liable for any money beyond their original investments.
A direct participation program shows the following operating results for the year: Revenues: $3 million Operating expense: $1 million Interest expense: $200,000 Management fees: $200,000 Depreciation: $3 million The cash flow from program operations is
$1.6 million. The cash flow for a direct participation program is the net income (or loss) plus the depreciation. In this question, there is a loss of $1.4 million. When the depreciation of $3 million is added to the negative $1.4 million, the cash flow is a positive $1.6 million. How did we get the loss of $1.4 million? The money that came in was the revenue of $3 million. From that, we subtract all of the expenses. Total operating expense of $1.2 million ($1 million plus $200,000 management fees) Interest expense of $200,000 Depreciation of $3 million Total expenses: $4.4 million Net loss of $1.4 million
A customer invests $20,000 in a direct participation program and signs a recourse note for $50,000. During the first year of operation, the customer receives a cash distribution of $15,000 from the partnership. At year's end, the customer receives a K-1 statement reporting his share of partnership losses of $75,000. How much of the loss may the customer deduct from passive income?
$55,000 A limited partner can only deduct partnership losses to the extent of his basis. To determine basis, add the original investment ($20,000) to any recourse debt assumed by the investor ($50,000). Recourse debt adds to basis as the partner is liable for this amount. Cash distributions received reduce basis ($15,000). At year's end, the investor's basis and the amount he can deduct from passive income is $55,000.
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?
$6,000 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.
An investor purchased one unit of a real estate limited partnership. The cost of the unit was $20,000. The investor's allocable share of nonrecourse debt was $50,000. During the first year, the investor received an income distribution of $5,000. What is the investor's current tax basis?
$65,000 The $20,000 purchase price of the unit is basis. Because this is a RELP, nonrecourse debt increases basis. That addition of $50,000 increases the basis to $70,000. Distributions reduce basis, and there was one of $5,000 bringing the basis down to $65,000. Remember, it is only real estate where nonrecourse debt increases basis. Recourse debt increases basis in any DPP.
Some limited partnership programs provide potential tax credits to partners. Which of the following typically provide potential tax credits? Rehabilitation of historic properties Equipment leasing Developmental oil and gas programs Government-assisted housing programs
1 & 4 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.
FINRA Rule 2310 defines a direct participation program as "a program which provides for flow-through tax consequences regardless of the structure of the legal entity or vehicle for distribution including, but not limited to, oil and gas programs, real estate programs, agricultural programs, cattle programs, condominium securities, Subchapter S corporate offerings and all other programs of a similar nature, regardless of the industry represented by the program, or any combination thereof." The rule places limits on the overall expenses and amount of broker-dealer compensation considered fair and reasonable. That limit is
15% of the gross proceeds. If the organization and offering expenses exceed 15% of the gross proceeds, FINRA considers that too high. The 10% limitation is on the amount of compensation received by a member firm for selling interests in the DPP. The 2% is the maximum charge in a DPP rollup if the firm wishes to solicit votes from the limited partners. The 5% is the FINRA markup policy and that does not apply to DPP
If your client's real estate limited partnership goes bankrupt, which of the following are paid before your client? Fellow limited partners The bank that holds the mortgage on the property The bank that holds the unsecured loans on the property The general partner
2 & 4 Creditors, both secured and unsecured, have priority over partners. Your client's fellow limited partners are paid at the same time as your client, and the general partner receives his money last.
An investment banking firm has been hired to roll up various partnerships into one master limited partnership. What is the compensation limit for this activity?
2% Maximum compensation in a limited partnership roll-up is limited to 2%. That amount must be paid to the brokerage firm, whether the partners vote for or against the proposed roll-up.
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 accelerated depreciation. depletion allowances. recapture of depreciation. tangible drilling expenses.
3 & 4 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.
Under Subchapter M of the IRC, a REIT can avoid taxation if it receives at least ____ of its taxable income from real estate and distributes at least ____ of that income to shareholders.
75%, 90% To avoid taxation as a corporation, at least 75% of the taxable income of a real estate investment trust (REIT) must be generated from real estate and at least 90% of that income is distributed to shareholders
A major risk associated with investing in DPPs is the lack of liquidity. What steps could the program sponsor take that could have the effect of increasing the liquidity of an existing program?
A DPP rollup A DPP rollup is a transaction involving the combination or reorganization of one or more limited partnerships into securities of a successor corporation. The securities of the successor corporation would likely have greater liquidity. This would have the effect of turning the illiquid DPP into more liquid securities. Disclosure documents must be provided to investors prior to the transaction disclosing risk, the GPs opinion regarding fairness of transaction, and reports and appraisals in connection with the transaction.
A direct participation program (DPP), organized as a limited partnership, must avoid at least two characteristics of a corporation. Which two characteristics are the easiest to avoid?
Continuity of life and freely transferable interests Continuity of life and freely transferable interests are the easiest to avoid. The limited partnership is formed to exist for a limited time, and general partner (GP) must approve any transfer of interests. Centralized management is the hardest characteristics to avoid because management of the program is the responsibility of the general partner (GP), so management is centralized.
If near-term liquidity were the only objective for a client, which of the following pairs of investments would represent the most/least liquid?
Exchange-listed equities/direct participation program 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.
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?
Functional allocation While both LPs and GPs share equally in the revenues with a functional allocation arrangement, it is most commonly used because it gives the best tax benefits to each. The LPs receive the immediate tax write-offs from the intangible drilling costs, whereas the GPs receive continued write-offs from the tangible costs over the course of several years.
A high-net-worth investor with substantial annual income likes real estate as a potential investment. The investor notes that any investment potentially offering tax credits would be most interesting to consider first. Which of the following would be suitable investments to discuss?
Historic rehabilitation and government-assisted housing direct participation programs (DPPs) REITs, either equity or mortgage, should be eliminated, as they offer no tax credits. Given the customer's high net worth and income, a discussion of DPPs is suitable. Of those DPPs shown here, only historic rehabilitation and government-assisted housing offer tax credits, and either should be suitable for discussion.
Which of the following oil and gas programs would be least risky?
Income For oil and gas programs, ranking from least risk to most would be as follows: income, developmental, and exploratory. Raw land is a type of real estate program.
Which of the following choices would generate the largest first-year deductions in an oil and gas exploratory drilling program?
Intangible drilling costs Intangible drilling costs (IDCs) would be the largest deduction in an oil and gas exploratory drilling program. These are also known as a wildcat program. This type of program attempts to discover oil or gas in an area where proven reserves have yet to be discovered. IDCs are deductible in the year incurred. The unpredictability and huge costs associated with drilling for oil and gas make this the largest deduction in an oil and gas wildcat program. The allowance for depletion comes into play only when the well begins producing and product is sold. Depreciation of the equipment can be taken in the early years, but it is not as significant as the full deduction for the IDCs. Recapture is not a deduction; it is reporting as income something previously deducted.
Which of the following best describes the advantages of an oil and gas income program, as compared to other types of oil and gas programs?
Lowest risk of capital Oil and gas income programs own producing wells and pass through their depletion allowances. There is little risk compared to other programs such as exploration.
One of your wealthier clients invests $100,000 into a real estate limited partnership (RELP) investing in shopping centers. 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 of reportable income for the year. Which of the following statements is true?
Passive losses may be carried over indefinitely, so the $50,000 can be used to offset the passive income generated by the new program. 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.
If a limited partner in a real estate direct participation program becomes involved in the management of the office building acquired by the partnership, which of the following is true?
That limited partner's limited liability is jeopardized. While the limited partners usually have limited liability, that benefit can be lost if a limited partner engages in certain activities, including the day-to-day management of the property, representing himself as a general partner, and financial control of the partnership.
A tool used by investment banking firms to combine several unsuccessful limited partnership programs into one new entity is
a DPP rollup. A DPP rollup is a transaction involving the combination or reorganization of one or more limited partnerships into securities of a successor entity. In general, this involves DPPs that have not been successful. The attraction to investors is the possibility of turning an illiquid DPP into a security with greater liquidity.
The type of REIT in which the issuer purchases real estate properties that produce income as well as mortgages on income-producing real estate properties is
a hybrid REIT. A hybrid REIT receives its name from the fact that it combines the strategy of an equity REIT and a mortgage REIT. On the equity side, it takes an ownership position in real estate properties. The goal is income from rentals with possible capital appreciation when the properties are sold in the future. On the mortgage side, they provide financing for income-producing real estate by purchasing or originating mortgages and mortgage-backed securities (MBS) and earning income from the interest on these investments. Therefore, the hybrid REIT deserves the name because it is a mixture of both types of REITs. A participating trust has nothing to do with REITs and will not be the subject of a question on your exam.
A company set up to invest in real estate, mortgages, construction, and development loans that must distribute at least 90% of its net income to avoid paying taxes on the income distributed is called
a real estate investment trust. A real estate investment trust, to avoid tax on its income, must distribute 90% of its net investment income to investors.
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
cash flow analysis. 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.
All of the following are characteristics of both oil and gas, as well as real estate limited partnerships,
deferral of benefits. depreciation. limited liability. A depletion allowance makes up for the using up of a natural resource. Real estate limited partnerships do not have depletion allowances. Both real estate and oil and gas partnerships offer limited liability, depreciation allowances, and deferred receipt of income and capital gains.
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
has a net worth sufficient to sustain the risks of the DPP, including loss of investment 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.
A blind pool offering
is one in which 25% or more of the properties are not specified Many times, large real estate or oil and gas programs are offered in the form of a blind pool. In a blind pool, 25% or more of the specific properties (in real estate) or sites (in oil and gas) have not been identified at the time of the offering. When investing in a blind pool, the participants are relying on the expertise of the program sponsor to select locations that will prove profitable.
All of the following are objectives in a direct participation program (DPP)
long-term capital gains. deductions against passive income. deferment of taxes. DPPs are used to defer present income into the future and take advantage of time. In doing so, any gains will be taxed at favorable long-term rates. The expected losses in the early years may be taken as deductions against passive income from other sources.
The general partner of an oil and gas drilling program might be considered to have a conflict of interest for all of the following reasons
managing the partnership. Managing the partnership is what the general partner's job is, so there would not be a conflict of interest. Owning a potentially competing project could be a conflict of interest. Commingling (combining) investor funds from different programs is not legal and would certainly present a conflict, as would borrowing money from the partnership
If a limited partnership interest is sold, the gain or loss in the sale is the difference between the sales proceeds and
the adjusted basis. The adjusted basis is a limited partner's cost basis at any point in time. Gain or loss on the sale of the partnership is determined by comparing the sales proceeds to the adjusted basis.
An investor in an equipment-leasing direct participation program (DPP) using straight-line depreciation would probably not be concerned about
the likelihood of recapture. Recapture of deductions is a concern when accelerated, but not when straight-line depreciation is used. In any business, there is always concern about the quality of the management. By and large, DPPs are not liquid investments, so an investor needing a quick sale may have problems. The nature of DPPs tends to make them more sensitive to legislative risk than most other securities.
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
the target must be based on the total production of associated persons with respect to all direct participation programs offered by the member. 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.
