Lesson 5.1: Direct Participation Programs Flashcards
You have a client who wishes to allocate a portion of his funds to investment real estate in an attempt to generate additional income. That goal could be reached by investing in any of the following:
I. real estate limited partnerships.
II. rental real estate.
III. REITs.
NOTE: Raw land does not generate income; it is most often held for future capital appreciation.
All of the following are features of limited partnership direct participation programs except
A) the general partner determines when distributions are made to the limited partners.
B) the limited partners have limited liability.
C) the limited partners may participate in the management of the partnership.
D) the general partner controls the business activities of the partnership.
C) the limited partners may participate in the management of the partnership.
Should a limited partner assume a management role, there is the danger that the limited liability protection will be lost and that partner will now have the same unlimited liability of a general partner. It is the general partner who manages the program; the limited partner is a passive investor.
Your client who owns a DPP that generated a $10,000 passive loss for the year could:
only deduct the passive loss against passive income.
Passive losses, such as those generated by limited partnership investments (DPPs), are only deductible against passive income.
All of the following would flow through as a loss to limited partners except
A) depletion.
B) principal repayment on partnership debt.
C) interest payments on partnership debt.
D) accelerated depreciation.
B) principal repayment on partnership debt.
Principal repayments are not an expense for tax purposes. The interest on the debt is an expense and, along with depletion and depreciation expenses, does flow through to the limited partners as passive loss.
In a DPP, a general partner is all of the following except
A) one who has limited liability.
B) one who buys and sells the program’s property.
C) one who appoints the property manager.
D) a key executive who makes day-to-day business decisions.
A) one who has limited liability.
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.
One of the benefits of being a limited partner in a direct participation program (DPP) is that:
the general partner is the only person liable for the debts of the business.
In a DPP, it is only the general partners who have full liability; limited partners are liable only to the extent of their investment plus any future commitments. Limited partners lose their status if they undertake any management responsibility. Losses are passive losses and can be deducted only against passive income, not ordinary income. It is capital losses that are subject to the $3,000 limit. Any income is treated as passive income, and that is taxed at ordinary income tax rates, not the lower capital gains rate.
An agent must obtain written verification of an investor’s net worth for which investment?
Direct participation programs (DPPs) require complete financial disclosure because of minimum suitability standards set by the states in which they are sold. REITs, unit investment trusts, and variable contracts do not have specific net worth suitability requirements for investors.
What is not a characteristic of owning a limited partnership?
Tax-free income
The income from limited partnerships is not tax exempt. An investor, however, may use a tax loss from a partnership to offset the income from another passive investment. In limited partnerships, the investor enjoys the advantages and disadvantages of owning a business without having to actually manage one. Limited partnerships are vulnerable to legislative changes that adversely affect ownership of such investments.
Which of the following statements regarding the general partner (GP) in a direct participation program (DPP) is not true?
A) The GP is the active investor in a limited partnership and assumes responsibility for all aspects of the partnership’s operations.
B) The GP, as the active manager of the partnership, does not maintain a financial interest in the partnership and only receives income distributions from profits on the business prior to the limited partners.
C) A GP has a fiduciary relationship to the limited partners (LPs).
D) The GP cannot borrow from the partnership, compete with the partnership, or commingle personal funds with partnership funds.
B) The GP, as the active manager of the partnership, does not maintain a financial interest in the partnership and only receives income distributions from profits on the business prior to the limited partners.
General partners (GPs) must maintain a financial interest in the partnership and generally do not receive distributions from profits before those paid to the limited partners (LPs). The GP is the active investor in a limited partnership and assumes responsibility for all aspects of the partnership’s operations and has a fiduciary relationship to the LPs. The GP, as a fiduciary, cannot borrow from the partnership, compete with the partnership, or commingle personal funds with partnership funds.
Which of the following must be considered in evaluating the suitability of a DPP investment for a customer?
I. Risk tolerance
II. Other holdings
III. Financial situation
IV. Age
ALL
The key here is to recognize that with DPPs, the customer’s age is a relevant consideration in determining suitability. DPPs are long-term, illiquid, high-risk investments. It is unlikely that DPPs would be suitable for a customer near retirement age, regardless of the customer’s financial situation.
A client invests $100,000 in a commercial real estate venture taking a 10% interest as a limited partner. Unfortunately, the demand for new office space deteriorates and the partnership is unable to meet the mortgage payments. The end result is foreclosure with a net loss of $2 million. This would have the effect of:
giving the client a passive loss of $100,000.
The most the client can lose is the amount of the investment, in this example, $100,000. Because DPPs are considered passive investments, the loss may only be deducted against passive income. As a limited partner, the loss is “limited” to the original investment. Sure, the client could always make a claim against the agent, but nothing in this question indicates that the agent did anything wrong so that would not be the “best” answer.
Which of the following statements is not true?
A) Management of the enterprise is solely within the jurisdiction of the general partner(s).
B) It is the general partners rather than the limited partners who bear the liability for partnership debt.
C) Limited partners are not liable for funds in excess of the amounts they have invested or otherwise committed for.
D) Limited partners have the option to actively manage the business operations.
D) Limited partners have the option to actively manage the business operations.
Limited partners are passive investors in a partnership whose liability is limited to the amount of funds they have invested and committed to but have not yet contributed. They do not manage the funds in the partnership; the general partner has that responsibility.
Many sophisticated investors have added alternative investments to their portfolios. Benefits in doing so include:
portfolio diversification.
Alternative investments, such as limited partnership vehicles and hedge funds, have a tendency to add diversification to a traditional stock and bond portfolio. Many alternative investments have little or no regulation, and their expenses are typically high. Although many alts offer the opportunity for higher returns, that opportunity is not always realized. Therefore, we cannot make a statement that the returns almost always generate higher returns than traditional investments.
Regarding the use of the term direct participation programs, when referring to tax-sheltered investments, which of the following is not a DPP?
A) Real estate limited partnership
B) Oil and gas limited partnership
C) Equipment leasing limited partnership
D) Real estate investment trust
D) Real estate investment trust
DPPs include any form of business that allows for the direct pass-through of tax consequences to participants. REITs do not allow for the pass-through of losses.
A REIT and a direct participation program are similar because they both:
are operated by a centralized management.
Both a REIT and a DPP are run by centralized management. A REIT may not pass through losses to its investors, and it is not a limited partnership. A DPP cannot be easily traded in the secondary market.
