What You Should Know About Partnerships for the Series 7 Exam
Certainly partnerships can be formed to run any sort of business that you can imagine, but the Series 7 exam focuses on the big three: real estate, equipment leasing, and oil and gas. You need to be able to identify the risks and potential rewards for each of the following types of partnerships.
Real-estate partnerships include programs that invest in raw land, new construction, existing properties, or government-assisted housing. You need to know the differences among the types of programs, along with their risks and potential rewards. Here are the types of real-estate direct participation programs (DPPs), from safest to riskiest:
Public housing (government-assisted housing programs): This type of real-estate DPP develops low-income and retirement housing. The focus of this type of DPP is to earn consistent income and receive tax credits. The U.S. government, via the department of Housing and Urban Development (HUD), makes up any deficient rent payments. Appreciation potential is low and maintenance costs can be high, but public housing DPPs are considered the safest real-estate DPP.
Existing properties: This type of DPP purchases existing properties, and the intent is to generate a regular stream of rental income. Because the properties already exist, this DPP generates immediate cash flow. The risk is that the maintenance or repair expenses will eat into the profit or that leases won’t be renewed. The properties are already producing income, so the risk for this type of DPP is relatively low.
New construction: This type of DPP purchases property for the purpose of building. After completing the construction, the partnership’s goal is to sell the property and structure at a profit. Building costs may be more than expected, and the partnership doesn’t receive income until the property is sold, but the DPP can benefit from appreciation.
Raw land: This type of DPP invests in undeveloped land in anticipation of long-term capital appreciation; raw land DPPs don’t build on or rent out the property. The partnership hopes the property purchased will appreciate in value so that the DPP can sell the property for more than the purchase price plus all expenses.
The following question tests your understanding of real-estate DPPs.
Which of the following types of real-estate DPPs has the fewest write-offs?
(A) Raw land
(B) New construction
(C) Existing properties
(D) Public housing
The correct answer is Choice (A). DPPs that invest in raw land are buying property and sitting on it with the hope that it’ll be worth more in the future. Because the DPP isn’t spending money on improving the property and land can’t be depreciated, raw land DPPs have the fewest write-offs.
Although you may be tested on equipment leasing programs on the Series 7 exam, it’s the least-tested type of DPP. The objective is to obtain a steady cash flow and depreciation write-offs. The two types of leasing arrangements you need to be aware of are the operating lease and the full payout lease:
Operating lease: This type of equipment leasing program purchases equipment and leases it out for a short period of time. The DPP doesn’t receive the full value of the equipment during the first lease. This type of arrangement allows the DPP to lease out the equipment several times during the life of the machinery.
Full payout lease: This type of equipment leasing program purchases the equipment and leases it out for a long period of time. The DPP receives enough income from the first lease to cover the cost of the equipment and any financing costs. Usually, the initial lease lasts for the useful life of the equipment.
Oil and gas
Oil and gas partnerships include programs that produce income, are speculative in nature, or are a combination of the two. You need to know how the types of programs differ, along with their risks and potential rewards. Oil and gas partnerships also have certain tax advantages that are unique:
Intangible drilling costs (IDCs): IDCs are write-offs for drilling expenses. These costs include wages for employees, fuel, repairs, hauling of equipment, insurance, and so on. IDCs are usually completely deductible in the tax year in which the costs occur. IDC deductions are only for the drilling and preparing of a well for the production of oil and gas. Therefore, when a well is producing, IDC write-offs are not allowed.
Tangible drilling costs (TDCs): TDCs are write-offs on items purchased that have salvage value. All oil and gas DPPs have TDCs, which include costs for purchasing items such as storage tanks, well equipment, and so on. These costs are not immediately written off but are depreciated over seven years. Depreciation may be claimed on either a straight-line basis or an accelerated basis.
Depletion: Depletion is a tax deduction that allows partnerships that deal with natural resources to take a deduction for the decreasing supply of the resource. Partnerships can claim depletion deductions only on the amount of natural resources sold.
For Series 7 exam purposes, exploratory programs are the riskiest oil and gas DPPs because oil may never be found, and income programs are the safest oil and gas DPPs.
The following question concerns different DPP investments.
Mr. Smith has money invested in a limited partnership that’s expecting to have a significant amount of income over the next one to two years. Which of the following programs would BEST help Mr. Smith shelter the MOST of that income?
(A) Oil and gas exploratory
(B) Raw land purchasing
(C) Equipment leasing
(D) Existing real-estate property
The answer you want is Choice (A). Oil and gas exploratory programs spend a lot of money attempting to find and drill for oil. These programs have high IDCs, which are fully tax-deductible when the drilling occurs. Therefore, the oil and gas exploratory programs have the largest write-offs in the early years, which could help offset some of the passive income from the other limited partnership.