Module 16 - Direct Participation Programs Flashcards

Question

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.

Answer 1

Remember for Test

Answer 2

* 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.

Answer 3

1. Secured lenders 2. General creditors 3. Limited partners 4. General partners

Answer 4

Remember for Test

Answer 5

- Nonmanaged offerings | - Managed offerings

Answer 6

- 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.

Answer 7

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.

Answer 8

- 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.

Answer 9

Remember for Test

Answer 10

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.

Answer 11

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

Answer 12

* The return of capital * Depreciation * Depletion * Expenses * Taxes to the partnership * Payments on principal * Other items

Answer 13

- 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.

Answer 14

- 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.

Answer 15

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)

Answer 16

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.

Answer 17

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

Answer 18

- 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.

Answer 19

- 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.

Answer 20

- 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.

Answer 21

- 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.

Answer 22

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.

Answer 23

- Exploratory - Developmental - Income - Balanced - Blind pool

Answer 24

Remember for Test

Answer 25

- 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.

Answer 26

- 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.

Answer 27

- 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.

Answer 28

- 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.

Answer 29

- 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.

Answer 30

- 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.

Answer 31

- Cost depletion | - Percentage depletion

Answer 32

- 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.

Answer 33

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.

Answer 34

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.

Answer 35

- 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.

Answer 36

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.

Answer 37

- 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.

Answer 38

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.

Answer 39

- EQUIPMENT LEASING PROGRAMS - CATTLE BREEDING PROGRAMS - COAL MINE PROGRAMS

Answer 40

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.

Answer 41

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.

Answer 42

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.

Answer 43

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!

Answer 44

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.

Answer 45

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.

Answer 46

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.

Answer 47

- 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.

Answer 48

``` 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 ```

Answer 49

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.

Answer 50

* 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.

Module 16 - Direct Participation Programs Flashcards

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