Quick Answer
A Real Estate Investment Trust (REIT) that distributes at least 90% of its taxable income avoids entity-level tax, and its ordinary dividends are taxed as ordinary income with no pass-through of losses. A Direct Participation Program (DPP) flows both income and losses to partners on a Schedule K-1, offering limited liability but very low liquidity.
The whole unit on one sheet: how REITs qualify and get taxed, how DPPs flow through income and losses, and the suitability lines the exam loves.
REITs vs. DPPs at a Glance
- REIT = a corporation, trust, or association pooling capital to own or finance income-producing real estate; governed by the REIT provisions of the Internal Revenue Code, not an investment company under the Investment Company Act of 1940.
- REIT flow-through is one-way: income passes to shareholders as dividends, but losses do NOT pass through to investors.
- DPP = any program providing flow-through of tax consequences; income, gains, losses, deductions, and credits all pass to partners via Schedule K-1, with no entity-level tax.
- DPP structure is usually a limited partnership: general partner (GP) manages with unlimited liability, limited partner (LP) is a passive investor whose liability is limited to the amount invested (plus any recourse notes signed).
- REIT types: equity (owns property, collects rent), mortgage (lends, collects interest, most interest-rate risk), hybrid (both).
- DPP types: real estate (lowest risk), oil and gas (exploratory, developmental, income), equipment leasing.
The One-Liners That Win Points
- 90% distribution rule lets the REIT avoid corporate-level tax; it does NOT mean 90% of distributions are tax-free. Shareholders still owe tax on what they receive.
- REIT ordinary dividends = ordinary income, not the lower qualified dividend rate. Return of capital reduces cost basis; capital gain distributions get long-term rates.
- 95% is an income test (where gross income comes from); 90% is the distribution requirement (how much income goes out). Do not swap them.
- Mortgage REITs carry the most interest rate risk. Rising rates compress the spread between mortgage yields and borrowing costs.
- DPP passive losses only offset passive income, never active (salary) or portfolio (dividend/interest) income. Suspended losses carry forward until there is passive income or full disposal.
- Partners owe tax on allocated income even if no cash is distributed (the crossover point produces phantom income).
- Oil and gas: risk and tax benefits are inverse. Exploratory (wildcat) = highest risk AND highest intangible drilling cost (IDC) deductions; income (producing) = lowest risk AND least tax benefit.
- Economic soundness test: a DPP must make sense without the tax benefits. Tax write-offs alone are never a reason to recommend it.
Numbers to Lock In
| Item | Value |
|---|---|
| REIT distribution rule | at least 90% of taxable income |
| REIT 75% income and asset tests | 75% from/in real estate sources |
| REIT 95% income test | 95% from qualifying sources plus dividends, interest, securities gains |
| REIT shareholder rule | at least 100 shareholders; 5/50 rule (no 5 owning over 50%) |
| Percentage depletion (oil and gas) | 15% of gross income (independent producers/royalty owners only) |
| Residential vs. commercial depreciation | 27.5-year vs. 39-year straight-line |
| Depreciation recapture on real property | maximum 25% |
| Total underwriting compensation cap | 10% of gross proceeds |
| Organization and offering expenses | presumed unfair above 15% of gross proceeds |
| Rollup solicitation compensation | 2% of exchange value |
| Non-cash compensation gift limit | $300 per person per year |
| Accredited investor thresholds | net worth over $1 million (excludes primary residence) or income over $200,000 single / $300,000 joint |
| Typical DPP hold | 7-12 years |
Top Gotchas
- Non-traded REITs are SEC-registered but NOT exchange-traded, so they are illiquid with limited redemption. Do not treat them like publicly traded REITs for suitability.
- A limited partner who participates in management, binds the partnership, or acts as its agent can lose limited liability and be treated as a general partner with unlimited liability.
- IDCs are immediately deductible; tangible drilling costs must be capitalized and depreciated. Consumed in drilling (labor, fuel, mud) = intangible; reusable equipment (pipe, tank, pump) = tangible.
- Percentage depletion is available only to independent producers and royalty owners, never to integrated (major) oil companies.
- Land is never depreciable; only the building and improvements qualify.
- PPM vs. prospectus: private placements (Regulation D) use a private placement memorandum; public offerings use a prospectus. Most DPPs are private placements, and even public DPPs have limited liquidity.
- Rollup compensation must be equal regardless of how the partner votes; a broker cannot earn more for delivering "yes" votes.
- Low-bracket investors, retirees needing income, and anyone needing liquidity are unsuitable for DPPs regardless of projected returns.
One-Breath Recap
A REIT distributes at least 90% of its taxable income to escape entity-level tax, pays ordinary-income dividends, and passes no losses through, while a DPP flows both income and losses to partners on a Schedule K-1 with limited liability but almost no liquidity. Lock in the REIT qualification percentages, the oil and gas inverse of risk and tax benefits, and the economic soundness test, and this unit answers itself.
Need more than the recap? This is a condensed summary. If it is not enough, read the full REITs and DPPs unit for the complete lesson.