Now that you've seen both limited partnerships and tenants in common, let's consolidate the characteristics that make DPPs unique, and the ones the exam tests most frequently.
Pass-Through Tax Treatment
The defining feature of all DPPs:
- Income, gains, losses, and deductions flow through to investors' personal tax returns
- No double taxation (unlike C corporations, where profits are taxed at the corporate level AND as dividends to shareholders)
- Investors receive a K-1 form annually
Tax limitations on losses:
- Passive activity rules: DPP losses are "passive" and can generally only offset passive income (not wages, salaries, or portfolio income)
- At-risk rules: investors can only deduct losses up to the amount they have "at risk" (their investment plus any recourse debt)
- These rules prevent investors from using DPP losses as unlimited tax shelters
Exam Tip: Gotchas
- DPP losses can only offset passive income, not wages or investment income
- "At-risk rules" limit loss deductions to the amount actually invested
Illiquidity
DPP interests are among the least liquid investments available:
- No active secondary market for DPP interests
- Interests are difficult to sell or transfer
- Investors should be prepared to hold for the life of the program, often 7 to 12+ years
- Not listed on exchanges (unlisted securities)
- This illiquidity is a major suitability concern
Exam Tip: Gotchas
DPPs are NOT listed on exchanges. They have no active secondary market. If a question asks about selling DPP interests on an exchange, the answer is that you cannot.
Suitability Requirements
FINRA imposes specific suitability obligations on who should invest in DPPs:
- DPPs are suitable only for investors who can bear the economic risk
- Investors must meet net worth and income requirements
- The registered representative must have reasonable grounds to believe the program is suitable for the specific customer
- The rep must conduct due diligence on the program before recommending it
- Compensation to underwriters and affiliates must be fair and reasonable
Exam Tip: Gotchas
The three things to remember about all DPPs: (1) pass-through taxation (no double tax), (2) illiquid (no secondary market), and (3) suitability requirements. If the exam describes an investment with these three features, it's describing a DPP.
With DPPs covered, let's move on to REITs, a way to invest in real estate without directly owning property.