Quick Answer
Three products sit outside stocks, bonds, and mutual funds: direct participation programs (DPPs) pass income and losses through on a K-1 with no double taxation; real estate investment trusts (REITs) must distribute at least 90% of taxable income to avoid entity tax; and hedge funds are private, accredited-investor-only pools using leverage and short selling. Liquidity and investor eligibility are the recurring tests.
The whole unit on one sheet: how each product is taxed, how liquid it is, and who may invest.
DPPs and Partnership Structures
- A direct participation program (DPP) passes income, gains, losses, deductions, and credits directly through to investors; no corporate-level tax, so no double taxation. Investors get a K-1 (never a 1099-DIV).
- Passive activity rules: DPP losses only offset passive income, not wages or portfolio income. At-risk rules cap deductible losses at the amount actually at risk.
- Illiquid: no active secondary market, not exchange-listed, often held 7 to 12+ years. Types: real estate, oil and gas, equipment leasing, agriculture.
- Limited partnership: a general partner (GP) runs the business with unlimited liability and unlimited authority; limited partners (LPs) are passive with liability limited to the amount invested. A GP is removed only by a majority LP vote. An LP who joins management risks GP treatment and unlimited liability.
- Tenants in common (TIC): each investor holds an undivided fractional interest and a separate deed; not a separate legal entity. Shares need not be equal, no consent is needed to sell, and there is no right of survivorship (not joint tenancy).
REITs: Structure, Types, and Tax
- A real estate investment trust (REIT) owns, operates, or finances income-producing real estate as a trust or corporation.
- Must distribute at least 90% of taxable income to avoid entity-level tax; a shortfall triggers a 4% excise tax.
- By investment: equity REITs own property and earn rent (some inflation protection); mortgage (mREIT) REITs lend and earn an interest spread (rate-sensitive, higher risk); hybrid REITs do both.
- By listing status: listed (exchange-traded, priced by supply and demand, liquid); public non-traded (SEC-registered but NOT exchange-traded, illiquid, upfront fees can exceed 10-15%); private (Regulation D, unregistered, least transparent).
- Dividends are taxed at ordinary income rates, not the qualified rate, because the REIT paid no corporate tax. Return of capital is tax-deferred but reduces cost basis, producing a larger gain at sale.
Hedge Funds
- A private investment pool for accredited or qualified investors; a limited partnership or limited liability company (LLC) with the manager as GP; K-1 pass-through.
- Exempt from Investment Company Act registration (small private-fund: 100 investors or fewer; qualified-purchaser: $5 million+ in investments each).
- "2 and 20" fees: 2% of all assets annually regardless of performance, plus 20% of profits; a high-water mark blocks double-charging on recovered losses.
- Lock-up periods (often 1 to 2 years), limited redemption windows, advance notice (30 to 90 days), and gates capping redemptions in stress.
- Strategies: leverage (no regulatory limits), short selling (unrestricted, theoretically unlimited loss), derivatives, concentration, global macro, long/short equity.
The One-Liners That Win Points
- DPP three-fer: pass-through tax, illiquid, suitability required. See all three, think DPP.
- LPs have LIMITED liability and LIMITED management rights; GPs have UNLIMITED both.
- REIT dividends = ordinary income; return of capital = basis reduction, not free money.
- "SEC-registered" is not "liquid": public non-traded REITs are registered yet highly illiquid.
- Inflation protection applies to equity REITs only, not mortgage REITs.
- "Hedge" does not mean "safe"; modern hedge funds are largely speculative.
Numbers to Lock In
| Item | Value |
|---|---|
| REIT distribution threshold | at least 90% of taxable income |
| REIT excise tax on shortfall | 4% |
| Stock-distribution cash minimum | at least 20% cash |
| Non-traded REIT upfront fees | 10-15%+ |
| TIC co-owner cap (like-kind exchange) | no more than 35 |
| Hedge fund minimum investment | $250,000 to $1 million+ |
| Accredited investor net worth | over $1 million (excludes primary residence) |
| Accredited investor income | over $200,000 single / $300,000 joint (each of the last two years) |
| Qualified purchaser | at least $5 million in investments |
| Hedge fund "2 and 20" | 2% of assets + 20% of profits |
Memory Aid
- LPs invest money, GPs make decisions: LIMITED liability always travels with LIMITED management rights, and UNLIMITED liability with UNLIMITED authority.
Top Gotchas
- Both LPs and GPs get a K-1, not a 1099; watch for the 1099-DIV distractor.
- TIC has no right of survivorship; the interest passes through probate.
- Mortgage REITs earn an interest spread, not rent, and lose value when rates rise.
- A hedge fund's exemption does not exempt the manager, who may still register as an investment adviser.
- Some non-traded REIT distributions come from borrowed funds or return of capital, not operating income; a steady yield can mislead.
One-Breath Recap
DPPs pass income and losses through on a K-1; REITs distribute 90% to dodge entity tax and pay ordinary-income dividends; hedge funds are private, illiquid, accredited-only pools charging 2 and 20. Nail taxation, liquidity, and eligibility, and the exam's alternative-investment questions answer themselves.
Need more than the recap? This is a condensed summary. If it is not enough, read the full Alternative Investments unit for the complete lesson.