SIE Chapter 10: Direct Participation Prgrams (DPPS) and REITs

Direct participation program. (DPP)

A limited partnership (common for real estate, oil and gas, and equipment leasing) that passes income, losses, and tax benefits directly to investors

• its illiquid but has tax advantages

• Can be public (SEC registered) or private (mostly to only wealthy individualas)

Limited partnerships must avoid at least 2 out of 4 of these to avoid being considered a corporation by the IRS

1) Centralized management 2) Limited Liability — These two are the hardest to avoid

3) Perpetual life 4) and Free transferability of interests — These two are easier to avoid because Limited Partnerships have a defined end date and LP interests require GP approval and suitability review to transfer

GP vs LP

General Partner (GP): Manages daily operations and has unlimited liability; they can’t compete with or borrow from the partnership

Limited Partner (LP): Provides capital, has voting rights but no management role, and has liability limited to their investment and any recourse debt

NOTE: Partnerships are usually set up as TIC (tenants in common)

Partnership agreement

Sets out partner’s rights and responsibilities; including the GP’s authority to charge management fees, sign contracts, decide on distributions and accept or reject new LPs

Certificate of limited partnership

The legal filing with the SEC for public offerings and the state that states the partnerships’s objectives, contributions, profit distribution, dissolution terms and transferability

• It must be amended for significant changes such as adding new LPs

Subscription agreement

The application a prospective LP completes and the GP signs to accept them

• It must go over the investor’s finances, a risk disclosure and a power of attorney letting the GP make investment decisions on the LP’s behalf

DPP Taxation

DPP income and losses are classified as passive

• Passive losses can only be written off against passive income from other DPPS not against other types of income

Evaluating DPPs

in Evaluating consider:

• The profitability of the program

• GP’s track record

• The program’s basic objectives

• The cost for an investor to buy in

Real Estate Limited Partnership (RELP)

These type of DPPs invests in raw land, new construction, existing properties or government assisted housing

Public (government assisted) housing DPP

Builds or improves low income housing and is backed by HUD subsidies

• This is the safest real estate DPP

Existing property DPP

Buys income-producing property for immediate rental cash flow

• main risks are maintenance costs and lease non-renewal

New construction DPP

Builds property to sell at a profit

• Theres no income until the sale and the construction costs can run over

• Sees good capital appreciation

Raw land DPP

Buys undeveloped land purely for appreciation

• There is no construction just the hope of capital appreciation of the land

• This is the riskiest DPP

Equipment Leasing DPPs (DPP purchases the equipment)

Operating lease: Short term leases that let the DPP re-lease the same equipment multiple times; faces the risk that the equipment becomes outdated

Full payout lease: One long-term lease that recovers the full cost of the equipment in a single lease term

Costs involved with oil & gas DPPs

Intangible drilling costs (IDC): Non-equipment drilling expenses (labor, fuel, transportation); these costs are tax deductible in the year they incur

Tangible drilling costs (TDC): Equipment with salvage value; the equipment is depreciated over several years for taxes

Depletion: A tax deduction for the shrinking supply of a natural resource such as oil and gas; The depletion is based on the amount actually sold not stored for later sale

OIl and Gas DPPS

Exploratory (wildcatting) program: Drills in unproven territory; highest risk and highest reward (has the most IDC)

Developmental program: Drills near existing producing oil wells; moderate risk

Income program: Buys already producing wells for immediate cash flow; least risk oil and gas DPP (and there is no IDC)

Combination program: Mixes exploratory, developmental drilling with income producing wells to offset costs

Real Estate Investment Trust (REIT)

Pools investor capital to buy real estate, mortgages, and construction loans

• Issues shares like a trust and trades in the secondary market rather than being redeemed with the issuer

• Unlike RELPS, real estate investment trusts only pass on income and gains to investors

Types REIT

Equity REIT: Owns income-producing property directly; income comes from rent and property sales

Mortgage REIT: Holds mortgages and construction loans; income comes from the interest on those loans

Hybrid REIT: Combines equity and Mortgage REIT income sources

For a REIT to avoid corporate level tax it must must meet these 3 criteria:

• At least 75% of income is real estate related

• At least 75% of assets are in real estate, government securities/cash

• At least 90% of net income is distributed to shareholders

Private REIT

Are exempt from SEC registration (Reg D)

• Their sold only to accredited and institutional investors

  • Generally illiquid

Public nonlisted REIT (PNLR)

Are SEC-registered but not exchanged traded REITs

• Their less liquid than listed REITs

Listed REIT

SEC registered and exchanged traded REIT

• The most liquid REITs