Key Takeaways
- REITs must distribute at least 90% of taxable income to maintain tax-advantaged status.
- REITs must invest at least 75% of assets in real estate and derive 75% of income from real estate.
- Equity REITs own and operate properties; Mortgage REITs hold mortgage loans.
- REIT dividends are typically taxed as ORDINARY INCOME (not qualified dividends).
- REITs trade on exchanges and provide liquidity; DPPs are highly illiquid.
- DPPs (limited partnerships) pass through income, losses, and deductions to investors.
- Limited partners have liability limited to their investment; general partners have unlimited liability.
- DPPs are suitable only for sophisticated investors who can afford total loss and don't need liquidity.
REITs and Direct Participation Programs
Real Estate Investment Trusts (REITs) and Direct Participation Programs (DPPs) provide alternative ways to invest in real estate and other ventures.
Real Estate Investment Trusts (REITs)
REITs allow investors to invest in real estate without directly owning property. They are structured as trusts and trade like stocks.
REIT Qualification Requirements
To qualify as a REIT and receive tax-advantaged status, a company must meet specific requirements:
| Requirement | Threshold |
|---|---|
| Income Distribution | Distribute at least 90% of taxable income |
| Asset Allocation | At least 75% of assets in real estate |
| Income Source | At least 75% of gross income from real estate |
| Shareholders | At least 100 shareholders |
| Ownership Limit | No more than 50% owned by 5 or fewer individuals |
| Entity Type | Organized as corporation, trust, or association |
Why 90% Distribution?
If a REIT distributes at least 90% of taxable income:
- The REIT pays no corporate income tax on distributed income
- Avoids double taxation (unlike regular corporations)
- Investors receive income and pay tax at their personal rate
If a REIT fails to meet this requirement:
- May lose REIT status
- Becomes subject to corporate income tax
- Could face penalties
Exam Tip: REITs must distribute at least 90% of taxable income. Most distribute 100% to avoid any corporate-level taxation.
Types of REITs
| Type | Investments | Primary Income |
|---|---|---|
| Equity REIT | Own and operate real properties | Rent from tenants |
| Mortgage REIT | Hold mortgage loans or MBS | Interest on loans |
| Hybrid REIT | Both properties and mortgages | Rent and interest |
REIT Characteristics
| Feature | Description |
|---|---|
| Liquidity | Trade on major exchanges like stocks |
| Diversification | Exposure to real estate sector |
| Income | Regular dividend payments |
| Professional Management | Managed by real estate professionals |
| Minimum Investment | Price of one share |
REIT Taxation
| Tax Aspect | Treatment |
|---|---|
| Dividends | Taxed as ordinary income (NOT qualified dividends) |
| Capital Gains | If REIT sells property, may distribute capital gains |
| Return of Capital | Reduces cost basis, not immediately taxable |
| State Taxes | May vary by state |
REIT Risks
| Risk | Description |
|---|---|
| Interest Rate Risk | Rising rates can hurt REITs (especially mortgage REITs) |
| Market Risk | Real estate values fluctuate |
| Sector Risk | Specific property types may underperform |
| Leverage Risk | Many REITs use debt financing |
| Economic Risk | Recessions affect occupancy and rents |
Exam Tip: REIT dividends are typically taxed as ORDINARY INCOME, not at the lower qualified dividend rate. This is an important distinction.
Direct Participation Programs (DPPs)
DPPs allow investors to participate directly in business ventures, passing through income, losses, and deductions.
DPP Structure
DPPs are typically organized as limited partnerships:
| Role | Liability | Involvement |
|---|---|---|
| General Partner (GP) | Unlimited | Manages the business, makes decisions |
| Limited Partner (LP) | Limited to investment | Passive investor, no management role |
Key DPP Characteristic: Pass-Through
Unlike corporations, DPPs pass through tax consequences directly to investors:
| Item | Treatment |
|---|---|
| Income | Passes to investors (K-1 form) |
| Losses | Passes to investors (subject to rules) |
| Deductions | Passes to investors (depreciation, etc.) |
| Credits | Passes to investors |
Types of DPPs
| Type | Investment Focus |
|---|---|
| Real Estate LPs | Commercial/residential properties |
| Oil and Gas Programs | Drilling, exploration, income |
| Equipment Leasing | Aircraft, railcars, containers |
| Agricultural Programs | Farming operations |
REIT vs. DPP Comparison
| Feature | REIT | DPP |
|---|---|---|
| Structure | Trust/Corporation | Limited Partnership |
| Liquidity | Trades on exchanges | Very illiquid |
| Pass-Through Losses | No | Yes |
| Tax Reporting | 1099-DIV | Schedule K-1 |
| Minimum Investment | One share | Often $5,000-$25,000+ |
| Investor Requirements | Any investor | Often accredited/sophisticated |
| Management | Professional | General Partner |
DPP Suitability
DPPs are suitable ONLY for:
| Investor Characteristic | Reason |
|---|---|
| High Net Worth | Can afford total loss |
| No Liquidity Needs | Cannot easily sell |
| Sophisticated | Understands complex risks |
| Long Time Horizon | Holding periods of 5-10+ years |
| Tax Situation | Can benefit from pass-through losses |
DPP Risks
| Risk | Description |
|---|---|
| Illiquidity Risk | No secondary market; difficult to sell |
| Business Risk | Venture may fail |
| General Partner Risk | GP decisions affect all investors |
| Tax Risk | Tax laws may change |
| Concentration Risk | Often single asset or sector |
| Total Loss Risk | May lose entire investment |
Limited Partner Liability
Limited partners' liability is limited to their investment amount:
| Scenario | LP Liability |
|---|---|
| Investment | $100,000 |
| Partnership loses $500,000 | LP loses maximum of $100,000 |
| Partnership sued | LP not personally liable |
Warning: If LP participates in management, they may lose limited liability protection and become liable as a general partner.
Exam Tip: DPPs are suitable ONLY for sophisticated investors who can afford total loss, don't need liquidity, and have long time horizons. They are NOT suitable for most retail investors.
How much of taxable income must a REIT distribute to shareholders to maintain its tax-advantaged status?
Which of the following can pass through losses to investors?
REIT dividends are generally taxed as:
A limited partner in a DPP invests $50,000. If the partnership incurs $200,000 in losses, the limited partner: