Chapter 11 Flashcards
REITs
Not categorized as investments under the IA Act of 1940, but is under Securities Act of 1933. BDs MUST send prospectuses to any investors who acquire shares in the primary market.
Mortgage REITs
Borrows funds from investors to invest in mortgages and earn income based on the difference between the mtg. rate and the rate of return paid to investors.
Equity REITs
These REITs own and operate income-producing RE.
Hybrid REITs
A combo of mtg. REITs and equity REITs.
True or false: REITs are always publicly traded?
False, REITs can be publicly or privately traded. Publicly traded REITs pay high dividends and are very liquid. These REITs appear on customers’ account statements at their listed price per share. Public REITs are initially sold in an offering that’s registered w/ the SEC.
Privately traded REITs and non-traded REITs are illiquid. These REITs appear on customers’ account statements at their estimated MV per share. Private REITs are initially sold in an exempt private placement that’s conducted under Regulation D. After their initial issuance, private REITs are not listed and don’t trade on the exchanges.
- Both non-traded and exchange-traded REITs invest in various types of real estate and are subject to the same tax consequences (90% distribution on taxable income).
- Since both types are registered, they’re required to make the same disclosures to investors.
Tax Treatment of REITs
There’s no double taxation on REITs if the REIT pays out 90% of its income to shareholders. In this case, the dividends are only taxed at the shareholder level. REITs CANNOT pass through losses.
- 20% of the income that REITs distribute to its investors is tax deudctible
What is needed for a REIT to qualify for special tax treatment?
- At least 95% of gross income must be derived from dividends, interest, and rents from real property.
- At least 75% of gross income must be derived from real property income.
- No more than 30% of gross income may be derived from the sale of stock or securities that have been held for last than 12 months.
True or false: Dividends investors receive from REITs is taxed at the LT capital gains rate?
False, it’s taxed as ordinary income
Direct Participation Programs (DPPs)
A business where the the results (CFs, income, losses) flow directly through to the investors. These can be formed as general partnerships, joint ventures, and Sub S Corp.
S Corp.
A corporation w/ 100 or fewer shareholders. The income from S Corps is not taxed but instead the shareholders pay the taxes.
Limited partnership
A business made up a general partner, the partner responsible for managing the program, and a limited partner(s) who are passive investors. The general partner MUST contribute to at least 1% of the overall partnership’s capital.
A limited partnership must register with the SEC unless it qualifies for an exemption under the provisions of the Securities Act of 1933.
The GP is also referred to as the sponsor.
- 20% of the income that limited partnerships distribute to its investors is tax deductible. Therefore, since 20% of the passive income from partnerships is deductible, the effective tax rate for investors who are in the highest tax bracket is 29.6%
Advantages of limited partnerships
- Favorable tax treatment: The partnership itself is NOT a taxable entity, but instead the tax burden is allocated to the partners’ personal tax returns.
- Limited liabilitiy
- Diversification
- Since the business doesn’t pay tax, limited partners may receive more income from a profitable DPP than from a profitable corporation. This is due to the fact that a corporation’s dividends are paid as after-tax distributions.
Disadvantages of limited partnerships
- Lack of control: GPs run the business, so the LPs don’t have control over day-to-day operations.
- Illiquidity
- Tax issues: Makes tax filings more complicated.
- Possible capital call
- Alternative minimum tax
True or false: Failure of an investor to meet the capital call may forfeit their interest in the limited partnership?
True
3 Documents Needed to Form a Limited Partnership
- Certificate of Limited Partnership
- Agreement of Limited Partnership
- The Subscription Agreement
Certificate of Limited Partnership
Sets the terms of the business relationship. Contents include:
- Name and purpose of the partnership.
- Name and address of each general & limited partners.
- The conditions under which the partnership will be terminated.
- Priority provisions in the event of partnership liquidation.
- This certificate must be filed w/ the respective state office.
Agreement of Limited Partnership
A contract between the GP and LPs. Content includes:
- The rights and obligations of the GP
- The rights and obligations of the LP
- Sharing arrangements for profits and losses
- Withdrawal terms for LPs
- Priority rankings in the event of a liquidation
The Subscription Agreement
Content includes:
* The amount to be invested
* To whom all the checks must be made payable and who must sign
* Suitability standards for the investment
* A statement that attests the investor’s ability to meet the financial requirements
* The parties who must sign the agreement (in most cases the GP and the LPs)
- Once a general partner accepts a limited partner’s subscription, the limited partner is considered a participant in the partnership. This acceptance of a limited partner is evidenced by the general partner’s signature on the subscription agreement.
Suitability Obligation
People who sell limited partnerships must ensure that the purchaser:
- Has read the prospectus/offering memorandum
- Understands the risk
- Has access to advice
- Has met all net worth, income, and suitability requirements
True or false: GPs also have limited liability?
False, GPs have unlimited liability
Activities the GP is restricted from engaging in:
- Competing w/ the partnership
- Testifying against the partnership
- Changing the business structure of the partnership
- Combining the LPs assets w/ the GP’s assets
- Borrowing money from the partnership
- Adding or substituting another GP
True or false: GPs are prohibited from lending money to the limited partnership at market rates?
False, they are permitted to lend but NOT to borrow.
Rights of LPs
- The right to inspect the books
- Call for the dissolution of the partnership by court decree
- Restrict the GP from discharging some duties
- Sue a GP or vote to remove a GP
- Engage in business that competes w/ the partnership
- Receive profits and comp. as stated in the Certificate of LP.
Priorities for distribution in the liquidation of a partnership
- Secured creditors
- General creditors
- Limited partners
- General partners
True or false: DPPs can raise money solely through pvt. offerings?
False, through public and private offerings
Managed offering vs Non-managed offering
Managed offering= When an underwriter forms a syndicate w/ other BDs to sell the securities.
Non-managed offering= When the sponsor hires a wholesaler to market the program. The wholesale then markets the program to BDs who then sell it to the public.
- Wholesaling arrangements must be disclosed in the prospectus/offering memorandum.
True or false: The IRS may declare that a limited partnership is offering an abusive tax advantage if the partners’ goals are just to shelter income?
True. The partners’ primary reason for the partnership must be the economic viability of the business.
Depletion
Depreciation of natural resources. These are two methods to calculate depletion: percentage and cost.
Under percentage depletion, a flat % of the income generated by the units is considered depletion.
Under cost depletion, adjusted property basis, # of recoverable units, and # of units sold must be known.
Tax credits
Different than tax deductions. Tax credits reduce taxes owed on a $ for $ basis. For example, if an investor owes $1k in taxes but has a $100 tax credit, they only owe $900.
- People can earn tax credits by rehabilitating commercial property build before 1936 and certain historic structures. Construction of government assisted housing also qualifies for a tax credit.
Recapture
When the investor recognizes too much D&A in the early years, and then sells the property the IRS will allow them to recapture some ordinary income.
True or false: Losses generated by passive activities may be deducted against passive gains or ordinary income?
False, losses generated by passive activities may only be deducted against income from passive activites. However, when the interest in a passive activity is sold, the taxpayer can deduct all of the passive losses that are being carried forward against passive or ordinary income.
True or false: Investment income (dividends, interest, or capital gains) may be offset w/ passive losses?
False, investment income may NOT be offset w/ passive losses.
A Partner’s Basis
The amount that the partner has at risk, which is the max. amount of loss they could experience.
Cost Basis Adjustments of a LP
Additions:
- Original contributions
- Any additional contributions
- Recourse loans
- Reinvestments of income
- Reinvestments of sales proceeds
Reductions:
- Passive losses claimed
- Any distributions of income
- Sales proceeds distributed by the partnership
RE Limited Partnerships
Limited partnerships that can invest in raw land, new construction, existing properties, or government-assisted housing.
Investing in raw land
Offers great potential for capital appreciation. Little or no depletion reductions can be taken against raw land.
Investing in new construction
Generally investors who build new construction are looking for capital appreciation but they may get some CF is the properties are leased to the tenants after construction.
This is a LT type of investment and the two key risks are shifts in policy and then supply issues. For example, the Austin situation in 2020 where now it’s overbuilt.
These investments are often highly leveraged.
Investing in existing properties
Typically safer investments than raw land or new construction, but have less upside for capital appreciation. Existing properties allows for immediate CFs and depreciation allowances.
Oil and gas limited partnerships
Partnerships designed for the exploration, drilling, or development of oil and natural gas.
- Passive losses may only be deducted against passive income. In any year, if passive losses exceed passive income, the excess losses are carried forward indefinitely to offset future passive income. When the partnership is sold, passive losses being carried forward become deductible against any source of income.
Exploratory program/Wildcatting
1/4 primary types of O&G limited partnerships. Searching for O&G in unproven areas. Due to the uncertainty, this is a high-risk endeavor. This investment offers major tax advantages.
Development program
1/4 primary types of O&G limited partnerships. Leases are acquired for the rights to drill in proven areas. Lower risk than wildcatting but lower potential upside. Step-out drilling is when drilling is being conducted just outside an area of proven reserves.
Balanced program
1/4 primary types of O&G limited partnerships. A combo of exploratory and developmental drilling.
Income program
1/4 primary types of O&G limited partnerships. Acquires interests in already-producing wells. These are acquired from oil and gas operators who have completed their drilling and do not want to hold the wells anymore. This is good for passive income. Depletion allowances can reduce taxable income. These are the best O&G programs for risk-averse investors who want current income.
Sharing arrangements
The method of allocating both costs and revenues. Usually, it’s through this agreement that the sponsor will receive a major portion of its
compensation
Functional Allocation Arrangement
1/4 primary types of sharing arrangements. W/ this, all of the deductible program expenditures are charged to the LPs while the non-deductible costs are borne by the GP.
Overriding Royalty Interests Arrangement
1/4 primary types of sharing arrangements. When the sponsor bears no part of the program costs, but shares in the production interest through royalties.
Reversionary Working Interest Arrangement
1/4 primary types of sharing arrangements. W/ this, the GP doesn’t share in any of the program’s costs, but the GP doesn’t get any production revenues until the LPs have covered their costs.
Disproportionate Sharing Arrangement
1/4 primary types of sharing arrangements. The GP is responsible for a % (usually 25%) of the program’s costs and gets a % (usually 50%) of the revenues.
Equipment Leasing Programs
A type of LP where a partnership is formed to buy equipment from manufacturers and then lease it to workers. There are signficiant tax benefits through depreciation w/ this.
Hedge funds
Not required to register w/ the SEC. Hedge funds are very illiquid. Hedge funds often charge much higher sales charges than the 8.5% max. that mutual funds are allowed to assess.
Fund of Funds
A portfolio of shares in different hedge funds. This provides more diversification but may result in higher fees and less liquidity.
Interval Funds
A closed-end fund that must be registered under the IAs Act of 1940 and is subject to the requirements of the Securites Act(s) of 1933 and 1934. Although these are closed-end funds, they do not trade on exchanges, nor do they trade at their NAV. Shareholders are only able to exit interval funds at certain intervals making them illiquid investments.
Interval funds are suitable for investors w/ a LT time horizon, looking for current income, and those seeking to diversify their portfolios. Fees tend to be much higher w/ interval funds than w/ closed-end funds or mutual funds.
Interval funds are higher risk than mutual or other closed-end funds
- The specific intervals these funds can be sold are stated in the prospectus.
- Interval funds offer investors a way to access types of investments typically only used by hedge funds.
Business Development Companies (BDCs)
A closed-end investment company that aids in the process of capital formation for small and middle-market companies. Since BDCs raise money through public offerings, there’s no requirement for investors to meet the sophistication, income, or net worth requirements.
BDCs are registered under the IAs Act of 1940 and must meet the requirements of the Securities Acts of ‘33 and ‘34.
- Most BDCs are listed on exchanges and trade at their current market price.
Taxation of BDCs
BDCs must distribute at least 90% of their earnings, and by doing this they are only required to pay taxes on the earnings they retain.
The crossover point
When a DPP’s revenues begin to exceed expenses.
Upon the sale of a limited partnership interest in a DPP, the BD should have the investor make his check payable to who?
Whoever is listed in the subscription agreement.
True or false: REITs pass through both gains and losses?
False, REITs pass through income; however, unlike partnerships, they don’t pass through losses.
