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Series 7 Flashcards > Module 16 - Direct Participation Programs > Flashcards

Module 16 - Direct Participation Programs Flashcards

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1
Q

DIRECT PARTICIPATION PROGRAMS (DPP)

A
  • Programs that allow for flow-through tax consequences such as LIMITED PARTNERSHIPS (LP)
  • The definition of a DIRECT PARTICIPATION PROGRAM includes programs that allow flow-through tax consequences and may include Subchapter S corporate offerings or programs that are similarly structured.
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2
Q

Limited partnerships are sold just like new issues of stock in that they have to be registered in the state where they will be sold. If they will be sold to the public, the limited partnerships must also be registered with the Securities and Exchange Commission (SEC). For this reason, limited partnerships are often sold through broker/dealers.

A

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3
Q

Limited partnerships are investment contracts that allow limited partners to invest in a common enterprise that is managed by a general partner (GP). The limited partners have limited liability and cannot lose more than the amount of money that they invest. This module refers to limited partnerships as the most common type of direct participation program and covers the information that is tested on the Series 7 Exam.

A

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4
Q

Tax Shelters Are Investments-for-Profit

A
  • Prior to 1986, most tax shelter programs (limited partnerships or direct participation programs) were constructed for tax write-offs and for converting ordinary income into long-term capital gains. This resulted in this income being taxed at a lower tax rate. After 1986, the ability to use limited partnerships as tax shelters changed; tax shelter income and tax shelter deductions began to be considered PASSIVE INCOME and PASSIVE LOSSES, respectively.
  • Passive income is taxable as ordinary income and PASSIVE LOSSES can only be deducted to the extent of passive income.
  • PASSIVE NET LOSSES cannot be deducted against ordinary income for tax purposes.
  • Capital losses, however, can be realized when selling or ending a partnership.
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5
Q

FICTIONAL PERSON

A

A partnership is considered a legal “FICTIONAL PERSON” or entity, which is formed under the laws of the state in which it is domiciled

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6
Q

The following laws govern partnerships:

A
  • The first law is the UNIFORM PARTNERSHIP ACT, which governs the conduct of partnerships.
  • The second law is the UNIFORM LIMITED PARTNERSHIP ACT (ULPA), which allows limited liability for those partners not designated as general partners.
  • The ULPA defines a limited partnership as “a partnership formed by two or more persons having as members one or more general partners and one or more limited partners.”
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7
Q

The requirements of ULPA have been satisfied if:

A
  • Two or more persons sign and swear to a certificate of limited partnership
  • The certificate has been filed with the secretary of state
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8
Q

Be familiar with the following three important documents (listed in order of importance, with section references in this module):

A
  • Certificate of limited partnership — Section 1.2
  • Partnership agreement — Section 1.3
  • Subscription agreement — Section 1.4
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9
Q

A corporation and a limited partnership have many things in common. To name a few, they are:

A

• To make money
• Have people in charge to run the entity — certain people run the entity, and may or may not own it.
• Continuity of Life — the entity continues to live as long as it is making money regardless of the CEO or any other officer. If any officer dies, goes insane, or goes bankrupt, most entities that are corporations will not be affected. As a corporation, the entity can live forever (some corporations have lived since the mid-1800s).
• Free-transferability of interest — buying and selling shares or units of the entity without a vote of other owners (usually shareholders) is allowed. The owners can buy or sell the shares or units at their own discretion.
• Limited liability of the owners (shareholders) — the owners can only lose the amount they have invested. Those running the company are not considered liable to creditors since they are employees of the entity and have less than 10% ownership in it.
• Centralized management — the owners do not manage the company; rather, the people managing the company have less than 25% ownership, and if the owners have less than 25% ownership, centralized management is said to exist.
***The last four items listed above are considered “Corporate Characteristics” and help determine, according to the tax code, if an entity is considered a corporation.

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10
Q

For an entity to have pass-through tax benefits as a Direct Participation Program, often called a Limited Partnership, the entity must not have more than two corporate characteristics. For this reason, most Limited Partnerships avoid two of the four following characteristics:

A
  • Continuity of Life — the partnership papers can state the limited partnership will end at a point in time, and the entity will cease to exist. This is the easiest characteristic to avoid.
  • Free-transferability of interest — the partnership papers require a vote of all partners for an owner to dispose of their interest. This causes the LP to cease to exist and is usually avoided.
  • Limited liability — management must own 10% or more of the partnership. Very few general partners put in 10%.
  • Centralized management — The GP is like the CEO of a corporation. Very hard to avoid this characteristic.
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11
Q

CERTIFICATE OF LIMITED PARTNERSHIP

A
  • A legal notice filed by the general partners with the secretary of state in every state in which the partnership will be offered. The certificate of limited partnership must contain information about the general and limited partners, including their names, addresses, amounts contributed, percentage ownership, and other information. The certificate also states the names and addresses of the people who could be served (must appear in court) for any problems that arise to the partnership.
  • This must be done for all of the partners and limited partners to eliminate personal liability for all debts. If any circumstances regarding the partnership change, the certificate must be amended within 30 days. This includes adding or deleting limited and/or general partners.
  • The partnership becomes a LIMITED PARTNERSHIP when the Certificate of Limited Partnership is filed with the secretary of state.
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12
Q

THE SUBSCRIPTION AGREEMENT

A
  • Prospective investors must fill out an application called a SUBSCRIPTION AGREEMENT when investing in a limited partnership. The subscription agreement includes the prospective investor’s name, address, telephone number, occupation, net worth, investing experience, and any other information that the general partner may want to know. The general partner then uses the information in the subscription agreement to determine whether the prospective investor is qualified to become a limited partner.
  • If the general partners are satisfied with the information provided in the subscription agreement, they will sign it. By signing the subscription agreement, the general partners accept the prospective investor into a limited partnership. At this point, the investor is only a prospective partner. The LP is not officially a partner until the partnership agreement has been signed by both the GP and LP.
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13
Q

THE PARTNERSHIP AGREEMENTS

A
  • A working document that outlines the rights and duties of both the GENERAL PARTNERS and the LIMITED PARTNERS in the PARTNERSHIP. The partnership agreement can be included in the Certificate of Limited Partnership, or it can be a separate document. This document is designed to protect the interests of the limited partners who do not have any direct input into the management of the partnership.
  • By signing the partnership agreement, the limited partner signs a POWER OF ATTORNEY that permits the GENERAL PARTNER (GP) to vote and act on behalf of the LIMITED PARTNER (LP). At this point, the investor is officially considered an LP.
  • The Partnership Agreement is a working document or investment contract between the general partners and the limited partners. The Certificate of Limited Partnership, on the other hand, which is filed with the secretary of state in each state, is a legal document for creditors.
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14
Q

The Partnership Agreement outlines:

A
  • The rights of the limited partners
  • The liabilities of the limited partners including the fact that the general partners can call upon the limited partners to make additional contributions
  • The profit sharing and compensation arrangements
  • The limits of involvement of the limited partners including the democracy provisions allowed to the limited partners.
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15
Q

The rights of the limited partners are outlined in the Partnership Agreement and include the right to:

A
  • Receive all information about the partnership and have the ability to inspect its books and records
  • Be treated as a GENERAL CREDITOR for any recourse loans made to the partnership
  • Receive any distributions as outlined in the partnership agreement
  • Sue in a court of law if the general partners fail to follow the provisions of the agreement; the limited partners cannot directly sue the general partners.
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16
Q

The DEMOCRACY PROVISIONS under ULPA grant the limited partners the right to do the following without losing their limited liability:

A
  • Vote to amend the partnership agreement
  • Sue in a court of law to remove a general partner
  • Sue in a court of law to dissolve the partnership
  • Vote to elect a new general partner, vote to let limited partners sell their units, and/or to let new limited partners into the partnership
  • Vote to approve the sale or refinancing of all or substantially all of the partnership assets
  • The right to inspect the books and records of the partnership
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17
Q

The limited partners may not sue the general partner; they can only sue to have the GP removed, and the court will take the action to remove the GP.
• Suing the GP is an act of management, and if the LPs sue the GP, they become the GP, and thus are personally liable for any losses suffered by the partnership.
• Using the courts to remove a GP is not an act of management; rather the courts are acting for the LPs.

A

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18
Q

The limited liability of the limited partners is outlined in the Partnership Agreement and states that:

A
  • Limited partners may only have limited involvement in the program without losing their LIMITED LIABILITY STATUS.
  • Limited partners’ liability must be limited to the amount of their investment plus any financing for which they sign.
  • A limited partner is sometimes referred to as a SILENT PARTNER
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19
Q

Limited partners can lose their limited liability status, become PERSONALLY LIABLE, and be classified as a general partner. This can happen if:

A
  • The limited partners knowingly let their names be used in the name of the partnership
  • The limited partners take control of management or in some way take the actions of management
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20
Q

GENERAL PARTNERS

A
  • The general partners in a limited partnership have a FIDUCIARY RESPONSIBILITY to the partnership as a whole and to the limited partners in particular. FIDUCIARY RESPONSIBILITY is defined as the responsibility to act in a prudent, responsible manner, and to act in the best interest of the partners and the partnership. Fiduciaries must place the interest of others, including those of the limited partners, ahead of themselves.
  • The general partners are obligated to obtain approval from all of the limited partners before they sell the property.
  • The general partners assume all the financial liability of the limited partnership that exceeds the invested capital of the limited partners.
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21
Q

Prior to investing in a limited partnership, an investor should take time to evaluate the investment. The following aspects of the investment must be reviewed:

A
  • The economic strength of the partnership
  • The basic objectives of the partnership
  • The partnership’s or the general partner’s track record, if any
  • The general partner’s previous investments (other limited partnerships), or if the investment has a sponsor, the integrity of the sponsor, and the success of past programs
  • The location and description of the property if the investment involves real estate
  • The anticipated return on the investments within the partnership
  • The pretax and after-tax effects of the program
  • The partnership’s anticipated cash flow and the return on investment, as well as the availability of automatic reinvestment
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22
Q

When evaluating direct participation programs, an investor should select the direct participation program with care and ensure that it is a suitable investment. The investor’s investment objectives must match the overall investment objectives of the direct participation program. Other factors that an investor should take into consideration in selecting a program are:

A
  • The extent that the investor is liable for future investment in the program. (The investor may have to contribute additional money to keep the program solvent.)
  • The legal liability of ownership in the direct participation program must be clearly stated in the offering documents and agreements.
  • The manner in which the investors are to be taxed.
  • The transferability of interests, if the need arises. Limited partnerships have a limited life, so what is the plan for the partnership upon dissolution?
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23
Q

FINRA has four suitability requirements that a registered representative of a broker/dealer should consider before selling a direct participation program to an investor:

A
  • The program must set forth its own suitability standards in the prospectus or offering document.
  • The investor must be in a financial position to realize the benefits described in the prospectus, including the tax benefits now or in the near future.
  • The investor must have a net worth significant enough to sustain the inherent risk or loss associated with direct participation programs as well as their relative lack of liquidity.
  • A registered rep may neither recommend nor sell an investment in a direct participation program to an investor for whom the investment is unsuitable.
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24
Q

A limited partnership is considered dissolved when:

A
  • The time or event as specified in the Certificate of Limited Partnership has been reached or occurred.
  • All the partners consent in writing to dissolve the partnership.
  • A general partner withdraws, dies, or is otherwise no longer able to continue as a general partner.
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25
Q

A limited partnership may be dissolved for many reasons, but this does not mean that it has to liquidate its assets and cease to conduct business.

A

Remember for Test

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26
Q

A limited partnership is LIQUIDATED when:

A
  • The remaining general partners take actions to liquidate the assets.
  • The limited partners successfully sue to dissolve the partnership in a court of law.
  • The courts take an action to liquidate the partnership.
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27
Q

When a limited partnership is liquidated, the order in which the claims (or debts) will be settled (or paid) without an agreement is:

A
  1. Secured lenders
  2. General creditors
  3. Limited partners
  4. General partners
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28
Q

When broker/dealers solicit customers with a limited partnership, they must have adequate policies and procedures to ensure that the investment is handled properly on behalf of the investors. The firm does not typically hold the funds that are received for the investment; rather, the funds are held in an escrow account at a bank. Additionally, broker/dealers must perform DUE DILIGENCE on the limited partnership by thoroughly reviewing the limited partnership documents, properties, or other aspects of the business for completeness and accuracy.

A

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29
Q

Two types of offerings can be undertaken by sponsors to make limited partnerships available to investors:

A
  • Nonmanaged offerings

- Managed offerings

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30
Q

NONMANAGED OFFERINGS

A
  • The sponsor (general partner) through the GP’s own full-time sales staff sells NONMANAGED OFFERINGS to the public, or the offering can be sold to the public through securities dealers, with the sponsor being in charge of the sale and the broker/dealers reporting to the sponsor. Usually, broker/dealers will help sell the issue on a best efforts basis.
  • A nonmanaged offering is an offering where no broker/dealer firm is in charge or responsible for selling the offering. The offering is sold on a best efforts basis.
31
Q

MANAGED OFFERINGS

A

MANAGED OFFERINGS are managed similarly to an underwriting of stocks or bonds. A securities firm acts as a wholesaler. An agreement to sell the limited partnership units is offered for broker/dealers to execute.

32
Q

SALES OF LIMITED PARTNERSHIP PROGRAMS

A
  • The sales of limited partnerships are governed by FINRA rules.
  • When a representative sells a limited partnership unit, the proceeds are deposited into an escrow account. When the sponsor, or general partner, pays the representative, the concession is deducted from the proceeds as a selling expense and is sent to the broker/dealer of the representative.
  • FINRA allows a maximum sales commission of 10% on the amount invested.
33
Q

All investors must receive a copy of the OFFERING CIRCULAR (or PROSPECTUS) no later than the SETTLEMENT DATE (the date payment is made).
• The offering circular for the limited partnership must be given directly to investors and not to their accountants or attorneys.
• All sales to prospective investors are contingent on the general partner accepting the limited partner.

A

Remember for Test

34
Q

INITIAL COST BASIS

A

The amount of money investors contribute to a limited partnership becomes their INITIAL COST BASIS. The initial cost basis is used for tax accounting to determine what, if any, tax liabilities are associated with the investment.

35
Q

COST BASIS, or BASIS, can be increased or decreased by various items.

A

Increases:
• With additional contributions or subsequent purchases of partnership units
• When the partner assumes a liability of the partnership, such as a mortgage loan for property contributed by the LP
• With distributions of taxable and nontaxable partnership income
• With distributions of excess deductions for depletion (excluding oil or gas wells)

Decreases (may never decrease below zero):
• When the partnership assumes a liability of a limited partner
• With distributions of partnership losses
• With distributions of partnership expenses
• With deductions for depletion

36
Q

The investor’s cost basis is further affected by:

A
  • The return of capital
  • Depreciation
  • Depletion
  • Expenses
  • Taxes to the partnership
  • Payments on principal
  • Other items
37
Q

RECOURSE LOANS

A
  • In recourse financing, lenders have the right to collect from the people who agree to be responsible for repaying the loan. Lenders can pursue these individuals for repayment by whatever means are available to them. For instance, individuals can use personal property, such as their house, as collateral for a recourse loan for a partnership; if the partnership defaults on the loan, the individual could lose his or her house as well.
  • If a limited partner lends money to the partnership in the form of a recourse loan, the partner has the right to be treated as a general creditor when it comes time to wind down the partnership.
  • The only time a recourse loan increases a limited partner’s cost basis is when the limited partner signs for the recourse loan and assumes complete responsibility for the loan.
38
Q

NON-RECOURSE LOANS

A
  • With a non-recourse loan, the lender cannot pursue the borrower if funds from the sale of the assets securing the loan are not sufficient to cover the loan. The lender incurs a loss on the difference between the loan amount and the amount that can be reclaimed by liquidating the assets used to secure the loan. The borrower is not at risk, because he or she has not committed any personal assets to secure the loan.
  • Unlike with a recourse loan, if a limited partner lends money to the partnership in the form of a non-recourse loan, the partner has no recourse to collect if there are not enough funds to cover the loan after the partnership winds down.
  • Non-recourse loans do not increase the basis of ownership for a limited partner, unless the loan is used for the purchase of real estate. This is because real estate has the potential to increase in value, whereas other assets decline in value.
39
Q

RECOURSE LOAN EXAMPLE

A

Example
An investor contributes $10,000 for a 10% basis in a partnership as a limited partner. The limited partner signs for a $20,000 recourse loan. What is the limited partner’s basis in the program?

Answer
$30,000 ($10,000 for the initial investment, plus the recourse loan amount of $20,000)

40
Q

NON-RECOURSE LOAN EXAMPLE

A

Example
An investor contributes $10,000 for a 10% ownership basis in a partnership. The partnership borrows a $200,000 non-recourse loan for building a business park. What is the investor’s cost basis as a limited partner in the program?

Answer
$30,000. The cost basis is $10,000 for the contribution, plus $20,000 (10% of $200,000) for the loan. However, the investor is not responsible for repayment of the debt.

41
Q

The four main types of REAL ESTATE PROGRAMS are:

A
  • New construction and the development of existing properties
  • Raw land
  • Government-assisted housing, known as Section 8 housing and Section 236 housing
  • Condominium ownership
42
Q

NEW CONSTRUCTION AND DEVELOPMENT OF EXISTING PROPERTIES

A
  • NEW CONSTRUCTION and the DEVELOPMENT OF EXISTING PROPERTIES PROGRAMS involve the construction of new buildings or the renovation of existing properties.
  • The main reason for investing in these programs is the potentially sizable long-term gains as well as the possible appreciation in the property’s value.
43
Q

RAW LAND

A
  • RAW LAND is land that has not been developed. RAW LAND PROGRAMS invest in land with the intention of developing it and selling it in the future at a higher price.
  • The main reason for investing in a RAW LAND PROGRAM is the potential for substantial appreciation, especially in areas of proposed development in high-population-growth areas. Most raw land programs experience negative cash flow in the early years since the land has yet to be developed. Therefore, an investment in a raw land program is not likely to be a suitable investment for investors seeking current income.
44
Q

GOVERNMENT-ASSISTED HOUSING

A
  • GOVERNMENT-ASSISTED HOUSING PROGRAMS are also known as SECTION 8 HOUSING PROGRAMS and SECTION 236 HOUSING PROGRAMS. Among other activities, these programs renovate existing properties or build new properties for low-income people to rent.
  • In the case of Section 236 housing programs, people rent with the option to purchase their house at a later date.
  • These programs have high-deduction and write-off potential, but they usually have very poor potential for increased property appreciation.
  • As a general rule, Section 8 and Section 236 housing are programs are developed by limited partnerships. Real Estate Investment Trusts, or REITs (discussed later in this module), do not invest in Section 8 or Section 236 housing programs.
45
Q

CONDOMINIUM OWNERSHIP

A
  • The partnership in CONDOMINIUM OWNERSHIP PROGRAM builds and then manages the renting, leasing, and sales of condominiums.
  • The partnership builds condominiums for home ownership with the intent to sell the property to homeowners, but it continues to manage the property.
    • One of the main features of a condominium limited partnership is the “rental pool.”
    • A rental pool is a program where all rents from leasing and renting the condominium units go into one pool of money and then that money is distributed to all owners of the condominiums, based on each condominium value, not on the rental value.
  • A condominium ownership program is usually attractive for those investors seeking longer-term income.
  • Management fees represent a small amount of current income.
46
Q

OIL AND GAS LIMITED PARTNERSHIP PROGRAMS

A

Involve the locating, drilling, and removal of oil and/or natural gas from reserves in the earth. Many costs associated with oil and gas programs are tax-deductible for investors.

47
Q

The five types of oil and gas programs covered in this module are:

A
  • Exploratory
  • Developmental
  • Income
  • Balanced
  • Blind pool
48
Q

Oil and gas programs are very risky investments because of the high probability of drilling dry holes. DRY HOLES are drilling efforts that do not result in finding useful oil or gas reserves. However, these programs do have very high tax write-offs allowed by the IRS.

A

Remember for Test

49
Q

EXPLORATORY PROGRAMS

A
  • EXPLORATORY PROGRAMS involve the drilling of wells that are not located in or near proven oil fields.
  • If oil or gas were found, the exploratory program would be extremely profitable because the cost of the drilling rights would increase significantly and the oil and/or gas could be sold to a developmental program for a much greater value than the cost of the drilling rights.
  • The drilling equipment is the responsibility of the drilling contractor. If the general partner is also the drilling contractor, the general partner is also responsible for the drilling liability as well as the general liability of the limited partnership.
  • This type of program is called wildcat drilling or “wildcatting,” because the explorers were characterized as risking everything on their oil exploration. The name “wildcatter” is applied to the individuals who risked capital to find oil.
  • Technology has reduced the risk of wildcatting that has historically been associated with these types of programs.
  • While the risk of DRY HOLES does still exist within the industry, recent technological advancements and innovations governing drilling programs have significantly reduced this risk. Therefore, technology has exponentially expanded the U.S. domestic reserve base. Because a high probability of the risk of dry holes no longer exists, they should no longer be represented and characterized as very risky investments.
50
Q

DEVELOPMENTAL DRILLING PROGRAMS

A
  • DEVELOPMENTAL DRILLING PROGRAMS involve the drilling of wells on proven property.
  • Developmental drilling programs have a lower risk of dry holes than exploratory programs. Consequently, developmental drilling programs experience appreciation and higher rates of return more frequently than exploratory programs. Such appreciation and rates of return are, again, the result of increasing property values as well as income from the sale of the oil or gas found.
  • Most of these programs are profitable, as long as the value of the oil or gas exceeds the partnership’s costs.
  • As in exploratory programs, the drilling equipment is the responsibility of the drilling contractor. If the general partner is also the drilling contractor, the general partner is responsible for the drilling liability as well as the general liability of the limited partnership.
51
Q

INCOME PROGRAMS

A
  • INCOME PROGRAMS involve the purchase of wells already producing oil or gas and then reselling the oil and/or gas to refineries and providers.
  • The objective of an INCOME PROGRAM is to purchase proven property that is already producing oil. The investment seeks to extract the resources and sell them.
  • These programs provide a steady stream of partially sheltered income to investors. This means that part of the income will not be taxed.
  • The income that must be claimed when the oil/gas is sold is offset with a DEPLETION ALLOWANCE (which is similar to depreciation; as oil is consumed, the value of the land is decreased). This reduces the amount of taxes that must be paid on the income.
52
Q

BALANCED PROGRAMS

A
  • A BALANCED PROGRAM combines characteristics of both development programs and income programs. Balanced oil drilling programs manage all aspects of oil exploration, drilling, and sales of the resources.
  • Many investors consider a balanced program an investment that involves less risk, because the balanced program is investing in production and sale of the raw resources. These programs are able to spread the costs over more revenues. A balanced program does not risk as much on the current price of oil; rather, it is investing for the long-term.
53
Q

BLIND POOL PROGRAMS

A
  • In a BLIND POOL PROGRAM, the investor does not know where the property is or what is going to be done; the investor just trusts the general partner.
  • Blind pool programs are usually very risky investments. These programs are used for write-offs and deductions rather than for income generation.
54
Q

DEPLETION ALLOWANCES

A
  • Programs that are involved in extracting natural resources through mining, pumping, or any other means, are reducing the amount of natural resources in/on the property.
    • This reduction of the natural resource reduces the value of the property when the property is sold.
    • That reduction can be deducted from the income received from the natural resource, and is called the DEPLETION ALLOWANCE.
  • The depletion of these WASTING ASSETS (e.g., oil, gas, timber, coal, precious metals, rock quarries, etc.) can be written off each year in which some of the natural resources are sold.
55
Q

There are two methods of writing off the cost of the assets:

A
  • Cost depletion

- Percentage depletion

56
Q

COST DEPLETION

A
  • COST DEPLETION is similar to depreciation in that each of the units (e.g., tons of coal or barrels of oil) is assigned a value according to the cost of the property and the number of units available. The number of units sold is multiplied by this value to determine the amount of depletion for the year.
  • Be sure to understand how to calculate the cost per unit as shown in the following example.
  • At no time can the total amount of cost depletion exceed the amount that is paid for the property.
57
Q

COST DEPLETION EXAMPLE

A

Example

A piece of property is purchased for $1,000,000. The property has an estimated 100,000 tons of coal in the ground. For the year, 20,000 tons are sold. To determine the amount of depletion for the year, do the following calculation:

$1,000,000 ÷ the 100,000 estimated tons = $10 per unit $10 × 20,000 units sold = $200,000, the depletion allowance for the year.

58
Q

PERCENTAGE DEPLETION

A

Percentage depletion is different than cost depletion. Percentage depletion is based on the sale of the natural resource versus the gross income for the limited partnership for that year. Cost depletion is based on the total value of the resource.
• Limited partnership programs that are invested in timber cannot use a percentage depletion method of writing off the cost of the trees, as they must use cost depletion.

59
Q

INTANGIBLE DRILLING COSTS

A
  • INTANGIBLE DRILLING COSTS (sometimes called IDCs) are only found in an oil and/or gas program. Intangible drilling costs are the costs to drill oil and/or gas shafts into the ground that can never be recovered.

Intangible drilling costs include:
• Costs and labor of drilling the hole
• Costs of clearing the well site
• Fuel and any other wages

  • Intangible drilling costs are taken in the year they occur.
60
Q

TANGIBLE DRILLING COSTS

A

Any costs associated with assets or equipment that can be taken to the next drilling site (such as pipe, drilling equipment, and trucks). These items are depreciated over time.

61
Q

DEPRECIATION

A
  • When property is purchased for business, whether real property (real estate) or personal property (cars, computers, desks and chairs, drilling equipment in an oil and gas program, or any other property other than land or buildings), the cost can be taken as a deduction spread over a period of years against the income earned by the business. This reduction in value of the asset is called DEPRECIATION.
  • DEPRETION is reducing the cost of an asset on the books of a corporation, limited partnership, or other business.
62
Q

CALCULATING DEPRECIATION DEDUCTIONS

A

DEPRETION deductions can be either straight line or accelerated, depending on the business’s tax strategy. Straight-line depreciation is taking the cost of the asset divided by the number of years that is outlined in the Tax Code.

  • The test will give you the life expectancy for the property.
  • Accelerated depreciation writes off the cost of the asset at a faster pace with large deductions in the early years and lower deductions in the latter years.

Example

An automobile is purchased by a limited partnership for $25,000. The automobile is a five-year property. Using the straight-line method for depreciation, the company will have a depreciation expense of how much for the next five years?
$25,000 ÷ 5 = $5,000 deduction each year.

63
Q

The different programs that could have a question on the exam:

A
  • EQUIPMENT LEASING PROGRAMS
  • CATTLE BREEDING PROGRAMS
  • COAL MINE PROGRAMS
64
Q

EQUIPMENT LEASING PROGRAMS

A

EQUIPMENT LEASING PROGRAMS are for purchasing capital equipment such as airplanes, locomotives, ships and large computers. A partnership is formed to purchase the equipment, which is then leased.
− The main reason is to generate income from the payments on the equipment leased.

65
Q

Two types of Direct Participation Programs involve cattle:

A
  1. CATTLE BREEDING PROGRAMS - used for developing herds of cattle through the propagation of calves that are grown and sold to cattle feeding programs.
  2. CATTLE FEEDING PROGRAMS involve raising and feeding cattle for food just prior to shipping the cattle to market.
66
Q

COAL MINE PROGRAMS

A

COAL MINE PROGRAMS are partnerships developed to mine and sell coal.
− Coal has a depletion allowance much like oil and gas, and can only be deducted when the coal is sold, not mined.

67
Q

PASS-THROUGH ENTITIES

A

A partnership is not subject to federal income tax as a business entity; instead, it is a PASS-THROUGH entity. The tax consequences are passed through to the individual partners who report their share of gains and losses on their own tax returns.

Example

A partnership has $100,000 in revenues, $40,000 in expenses, $20,000 in interest cost, and $10,000 in management fees. How much will be passed through to an investor who is a 10% partner?
$40,000 expenses
$20,000 interest cost
+ $10,000 management fees
$70,000 in deductions
$100,000 revenues - $70,000 = $30,000.
$30,000 × 10% partnership interest = $3,000 in gains to the investor.

If the excess is a loss, it will also flow through to the investor.

Example

A partnership has $200,000 in revenues, $100,000 in expenses, $70,000 in depreciation, $50,000 in interest cost, and $40,000 in management fees. What is passed through to a 10% investor?
$100,000 expenses
$70,000 depreciation
$50,000 interest cost
+ $40,000 management fees
$260,000
$200,000 revenues – $260,000 = $60,000 loss.
$60,000 × 10% partnership interest = $6,000 loss, which is passed through to the investor.

***In the above example, the investor can deduct the loss from the partnership against other passive income or against passive capital gains; however, the investor cannot deduct the loss from ordinary income!

68
Q

DETERMINING COST BASIS

A

You may have to calculate the new COST BASIS for an investor who has used a DEPLETION ALLOWANCE or deducted a DEPRECIATION EXPENSE along with the receipt of a CAPITAL DISTRIBUTION from the partnership.
• A Capital Distribution is a distribution of money that, after expenses, is being passed through to the investor.
• The Depreciation Expense or Depletion Allowance is also passed through to the investor.
• Depreciation Expenses and Depletion Allowances are deductions from the investor’s cost basis each year. On the exam, you may be given a cost basis, the depletion allowance or depreciation expense, and the capital distribution, and then asked to calculate the new cost basis.

69
Q

To calculate the new cost basis:

A
  1. Deduct the capital distribution from the given cost basis.
  2. Then, deduct the depletion allowance or the depreciation deduction, whichever is given, from that answer.

Example
An investor has a cost basis of $30,000. For the year, the investor has depreciation of $9,000 and a capital distribution of $7,000. What is the investor’s basis at the end of the year?

Answer:
$30,000 original cost basis
- $7,000 capital distribution
- $9,000 depreciation
$14,000. This is the investor’s new cost basis at the end of the year.

• Note that the deductions are made in two steps. This is the correct way to do this.
− If the capital distribution plus the depletion allowance/depreciation are less than the total cost basis, you can add them together before deducting from the cost basis.
– i.e., $7,000 + 9,000 = 16,000, which is less than $30,000
– If the two items are more than the cost basis, the deduction for depreciation cannot be more than the cost basis. Therefore, deduct the capital distribution from the cost basis first. Then, deduct the depreciation or depletion from the amount of cost basis remaining. You will have an amount of depreciation or depletion that cannot be deducted. The final cost basis will be zero.

70
Q

TRADE AND BUSINESS EXPENSES

A

TRADE AND BUSINESS EXPENSES are considered passive losses, which can be deducted against income from another partnership but not from the investor’s ordinary income.
• Trade and business expenses are listed on the test as passive losses, or just “losses” — they are not deductible from ordinary income.

71
Q

CROSSOVER POINT

A
  • Every partnership has a point at which it is more advantageous to either sell the partnership or refinance some or all of the loans. This happens when limited partners have more income (for IRS purposes) than they are actually receiving.
  • The CROSSOVER POINT is the point at which a limited partner’s taxable income is greater than the cash flow (amount received). The result is PHANTOM INCOME.
72
Q

ABUSIVE TAX SHELTERS

A 
Sponsors of ABUSIVE TAX SHELTERS have attempted to promote investments that take advantage of tax loopholes, yet are not allowed by the IRS as legitimate tax deductions. The IRS has deemed some investment sponsors fraudulent. If the IRS deems that an investment has been established for tax write-off purposes and not as a business for legitimate purposes, the IRS can pursue the investors and hold them responsible.
The IRS can make the investor incur:
- Additional taxes 
- Possible loss of tax credits 
- Interest and penalties
73
Q

A REAL ESTATE INVESTMENT TRUST (REIT)

A

A REAL ESTATE INVESTMENT TRUST (REIT) is a tax-advantaged investment that is owned by shareholders, not limited partners. A real estate investment trust invests in a portfolio of real estate with the intention of profiting from rents and the appreciation of the property.

74
Q

Distinguishing features of REITs include:

A
  • The IRS treats them like investment companies in that they must pass-through at least 90% of their net investment income to their investors.
  • They are just like any other company, such as IBM; however, their main purpose is to invest in real estate instead of making a product.
  • 75% of their income must come from real estate-related sources.
  • For equity REITs, the main source of income is the difference between their rental income and their mortgage payments.
  • REITs issue their stock in PUBLIC OFFERINGS; investors can then sell their shares back to the company or to another investor.
  • Real estate investment trusts must be distinguished from direct participation programs and investment companies because a REIT only resembles either of these for the “flow-through” tax consequences of the investment income and potential capital gains and losses. REIT shares are publicly traded and may be listed on an exchange or sold OTC.
  • Since real estate investment trusts must return at least 90% of their net investment income to investors, investors should receive some return on their investment each year.
  • REITs are distinguished from limited partnerships through their tax treatment of passive losses. Both REITs and limited partnerships pass through income, capital gains, and capital losses, but REITs cannot pass through passive losses.

Series 7 Flashcards (10 decks)

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