Alternative Investments Flashcards
A hedge fund is a:
A. management company as defined under the Investment Company Act of 1940 that is only open to accredited investors
B. management company that has an objective of limiting risk by hedging its portfolio positions with derivatives
C. private investment fund for sophisticated, accredited, investors
D. private investment fund that can only invest in privately held companies
The best answer is C.
A hedge fund is a private investment fund that uses sophisticated investment strategies and leverage to enhance returns but also takes on higher levels of risk. Hedge funds are typically limited to 99 investors so they do not have to register as investment companies under the Investment Company Act of 1940 (which states that registered investment companies are those that have at least 100 investors).
Hedge funds are:
I managed
II non-managed
III registered
IV non-registered
A. I and III
B. I and IV
C. II and III
D. II and IV
The best answer is B.
A hedge fund is a private investment fund that uses sophisticated investment strategies and leverage to enhance returns but also takes on higher levels of risk. Hedge funds are typically limited to 99 investors so they do not have to register as investment companies under the Investment Company Act of 1940 (which states that registered investment companies are those that have at least 100 investors).
A hedge fund limited partnership must have at least:
A. 1 general partner
B. 1 limited partner
C. 1 general partner and 1 limited partner
D. 2 limited partners
The best answer is C.
A limited partnership must have at least 1 general partner (the manager who assumes unlimited risk) and 1 limited partner (the investor, who can only lose his or her investment). There can be multiples of either.
Hedge fund investments are:
I liquid
II illiquid
III redeemable
IV not redeemable
A. I and III
B. I and IV
C. II and III
D. II and IV
The best answer is D.
Hedge funds are limited partnership private placements. They are highly illiquid and are not redeemable.
When discussing hedge funds with customers, the registered representative should make the customer aware that hedge funds:
I often hold illiquid investments
II use leverage and other speculative practices
III place limitations on withdrawal of funds
IV are not regulated and offer much less investor protection
A. I and II only
B. III and IV only
C. I, II, III
D. I, II, III, IV
The best answer is D.
Hedge funds are set up as private placements, open only to accredited investors. They are not regulated as investment companies and are subject to minimal regulatory oversight. They are illiquid, since money can only be withdrawn once per year (and usually only with general partner approval). They use sophisticated aggressive investment strategies that are high-risk (but these can also be high-reward), including short selling, using large amounts of leverage, and speculating in futures, commodities, and foreign currency markets. Many of these are illiquid investments. Because of their aggressive trading tactics, high levels of risk, and the fact that there is minimal regulatory oversight, they are only suitable for sophisticated, wealthy investors that are able to bear risk.
To form a limited partnership, there must be at least:
A. 1 limited partner and 1 general partner
B. 1 general partner for every 10 limited partners
C. 1 limited partner for every 10 general partners
D. 100 limited partners
The best answer is A.
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 investment.
All of the following statements are true for both limited partnerships and corporations EXCEPT both limited partnerships and corporations:
A. limit liability for the business owners
B. have centralized management
C. allow for “flow-through” of gain and loss
D. are formed with business intent
The best answer is C.
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 limited partners and corporate shareholders have limited liability; both have centralized management; and both are formed to operate a business.
Which of the following statements are TRUE regarding investments in a real estate limited partnership?
I Real estate limited partnership investments are considered passive investments
II Real estate limited partnership investments are illiquid
III Tax deductible losses are obtained through depreciation deductions, while positive cash flow is generated
IV When the real estate is sold, capital gains may be generated
A. I and II only
B. III and IV only
C. I, II, III
D. I, II, III, IV
The best answer is D.
Limited partnership interest are not liquid - 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. Finally, when the real estate owned by the partnership is sold, there is the potential for capital gains.
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
A. I and II only
B. III and IV only
C. I, III and IV
D. I, II, III, IV
The best answer is D.
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 27½ 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.
All of the following are risks of investing in a Real Estate Limited Partnership (RELP) EXCEPT:
A. Business risk
B. Liquidity risk
C. Regulatory risk
D. Reinvestment risk
The best answer is D.
Limited partnerships are illiquid - they do not trade and a limited partner can only sell his or her unit with general partner approval. So liquidity risk is a major issue. Because these are tax shelters that use provisions of the tax code to reduce tax liability, owners of limited partnerships face increased risk of tax audit; and also are subject to regulatory risk, which is the risk of tax law change.
There are no dividends or interest payments received that must be reinvested, so there is no reinvestment risk. However, business risk is another big issue here - because the business venture may fail.
When evaluating an investment in a direct participation program, all of the following are relevant considerations EXCEPT:
A. Experience of the general partner(s)
B. Economic viability of the business venture
C. Experience of the limited partner(s)
D. Objectives of the program
The best answer is C.
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.
The Alternative Minimum Tax is targeted at:
I high-income taxpayers
II low-income taxpayers
III with a low level of tax deductions
IV with a high level of tax deductions
A. I and III
B. I and IV
C. II and III
D. II and IV
The best answer is B.
The AMT (Alternative Minimum Tax) targets high income taxpayers that use “preferential methods” in the tax code to load up on deductions to excessively reduce their taxable income. These excessive deductions are called “tax preferences,” and the AMT basically adds these back to that person’s reported taxable income and taxes them.
All of the following are “preference” items included in the alternative minimum tax computation EXCEPT:
A. Excess intangible drilling costs
B. Straight line depreciation
C. Excess depletion
D. Excess depreciation
The best answer is B.
Excess intangible drilling cost deductions, excess depletion, and excess depreciation (amounts over straight line) are all tax preference items included in the Alternative Minimum Tax (AMT). Straight line depreciation is not included, nor are tax credits.
Which of the following are “preference” items included in the alternative minimum tax computation?
I Excess intangible drilling costs
II Excess depletion
III Straight line depreciation
IV Tax credits
A. I and II
B. II, III, IV
C. I, II, IV
D. I, II, III, IV
The best answer is A.
Excess intangible drilling cost deductions, excess depletion, and excess depreciation (amounts over straight line) are all tax preference items included in the Alternative Minimum Tax (AMT). Straight line depreciation is not included, nor are tax credits.
When comparing the Alternative Minimum Tax calculation to the Regular income tax calculation, which deductions are ONLY permitted in the Regular income tax calculation?
I Personal exemption
II State and local tax deduction
III Miscellaneous itemized deductions
IV Medical expense deduction
A. I and II only
B. III and IV only
C. I, II, III
D. I, II, III, IV
The best answer is C.
When calculating the Alternative Minimum Tax, aside from adding back “tax preferences,” many of the basic deductions permitted when calculating Regular income tax are not allowed, increasing the amount of AMT income that is subject to tax. When calculating AMT, there is no deduction for the personal exemption; no deduction for state and local taxes paid (including property taxes paid); no deduction for miscellaneous items such as tax preparation fees; and no standard deduction; among other items.
Medical expenses are deductible from Regular income tax to the extent they exceed 7.5% of Adjusted Gross Income (AGI). They are also deductible from the AMT computation, but for AMT, they are only deductible to the extent they exceed 10% of AGI.
