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DPPs: what counts, statement values and passive losses

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Flow-through makes a DPP, in any industry. Then three questions follow: what is it worth on paper, what can its losses offset, and when is its income taxed?

Definition, value, losses, income

FINRA Rule 2310 defines a direct participation program by one feature: flow-through tax consequences, whatever the legal entity. Its examples include oil and gas, real estate, agricultural and cattle programs, condominium securities and Subchapter S corporate offerings, plus programs of a similar nature in any industry. Real estate investment trusts, tax-qualified pension and profit-sharing plans, IRAs and registered investment companies are excluded.

Unlisted DPP units have no market price, so FINRA Rule 2231 requires the account statement to show a per-share estimated value, developed by a method designed to be reliable. The statement must also say the units are not listed, are generally illiquid, and may sell for less than the estimate. Where the statement uses a net-investment value (the amount left for investment after sales commissions and offering costs), a return of capital reduces it.

Flow-through decides who reports the results; the passive loss rules decide what a loss can offset. The tax code generally treats a limited partner as not materially participating, so her share is passive. Passive losses offset passive income. Any excess is disallowed for the year and carried to the next year. It does not reduce a salary.

Income works the other way. Each partner reports her share of partnership income from the Schedule K-1 whether or not the partnership pays out cash, because a distribution does not determine her share. Tenancy-in-common interests are a separate form: investors seeking a Section 1031 exchange buy them because the exchange needs an interest in real estate, not in a partnership.

Exam terms

Direct participation program
A program with flow-through tax consequences, in any industry and any legal form.
Per-share estimated value
The figure an account statement must show for an unlisted DPP or REIT security.
Passive activity
A business in which the taxpayer does not materially participate.
Material participation
The test for passive status; a limited partner is generally treated as not meeting it.
Distributive share
A partner’s share of partnership income or loss, reported on the K-1.
Section 1031 exchange
A tax-deferred swap of real estate for real estate; a partnership interest does not qualify.

Four questions about a DPP

Direct participation programFlow-through tax treatment
  • What countsRule 2310
    • Any industry, any entity
    • REITs, IRAs, registered funds excluded
  • What it is worthRule 2231
    • Per-share estimated value
    • Unlisted, illiquid, may sell for less
  • What a loss offsetsPassive loss rules
    • Passive income
    • Excess carried forward
  • When income is taxedSchedule K-1
    • Each year, cash or no cash
Flow-through answers who reports; the other rules answer what it is worth and what it offsets.

Try it: Say whether each is a DPP under Rule 2310: a cattle-feeding program with flow-through; a listed REIT; a registered closed-end fund; an equipment-leasing LLC with flow-through. Then say what a limited partner with a salary and no passive income does with a K-1 loss this year.

The ruleDPP = flow-through program, any industry or entity; REITs, IRAs and registered funds are excluded. Unlisted units show an estimated value, not a bid. A limited partner’s loss is passive: it offsets passive income, and the rest carries forward. Income is taxed each year, distributed or not.

The closest contrast

Flow-through: who reports.

Passive rules: what it offsets.

This decides loss questions. Pass-through puts the loss on the partner’s return; the passive rules then stop it offsetting wages or other non-passive income.

Worked example

Thorvald Quilliam holds units of an unlisted real estate limited partnership and earns a salary. He has no other passive investments.

  1. His statement shows a per-share estimated value with the required warning: the units are unlisted, generally illiquid and may sell for less.
  2. This year the partnership reports a loss. His share is passive, so it does not reduce his salary; it is disallowed now and carried to next year.
  3. Next year the partnership earns income but keeps the cash to repay a loan. He still reports his share of that income from his K-1.
  4. The loss carried from last year can offset that passive income.

Check yourself

Try a question, then read the explanation to review the rule.

Opening your study record…

Same rule, new context

Opening your study record…

Summary

  • A DPP is any flow-through program, in any industry or legal form; REITs, IRAs and registered investment companies are excluded.
  • An unlisted DPP statement shows an estimated value, and warns that the units are illiquid and may sell for less. Under a net-investment value (money left for investment after offering costs), a return of capital reduces the estimate.
  • A limited partner’s share is generally passive: losses offset passive income, and the excess carries forward.
  • Partners are taxed on their share each year, cash or no cash. Section 1031 investors buy TIC interests because a partnership interest does not qualify.

Related practice

  • Direct participation program structure and recommendationsPractice this
  • DPP tax character: passive losses and income without cashPractice this

Sources

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