REITs, DPPs and hedge funds

Liquidity varies inside the same structure. A listed REIT trades on an exchange like any other share, so investors can normally seek to sell in the market. Execution and the sale price are not guaranteed. A non-traded REIT is not listed at all, and an investor who wants out may have to wait for a limited repurchase program or a sale of the underlying property. Same tax treatment, completely different ability to leave.

Non-traded REITs can have substantial up-front fees and limited opportunities to sell. Distributions may come from offering proceeds or borrowing as well as property income. Receiving cash does not prove that the properties earned that amount or that the investor can recover the purchase price.

A direct participation program offers flow-through tax treatment. A limited partnership is one common form, but it is not the only legal structure. Income, gains, losses and credits pass through to the individual partners rather than being taxed at the entity, which is why these were historically sold for their tax characteristics. DPP interests are generally illiquid and unlisted. In a limited partnership, a general partner manages the venture, while a limited partner generally has no obligation to contribute additional capital and does not run it.

A hedge fund is a privately offered pooled vehicle, sold through an exemption to investors meeting financial or sophistication criteria rather than registered for public sale. Its strategies can include leverage, short selling and concentrated positions. Some registered funds also use such strategies within their regulatory limits; the distinction is not that each technique belongs only to hedge funds. Hedge funds are not subject to the protections that apply to mutual funds and ETFs, such as daily redemption at NAV and limits on leverage. They are not marketed to the general retail public.

Unregistered is not unregulated, and that distinction is worth holding on to. A hedge fund is subject to the same prohibitions against fraud as every other market participant, and its manager owes a fiduciary duty to the fund being managed. The exemption is from the registration and investor-protection regime, never from the law against deceiving people.

A DPP’s tax structure does not remove its risks. Read the program terms and consider whether an illiquid investment fits the investor’s need for cash. Do not assume that the program’s assets or a useful tax feature provide a ready way to sell its units.

Three tax facts separate these structures and are worth stating plainly, because a question can be built on any one of them. A partnership generally does not pay federal income tax at the entity level: it files an information return and hands each partner a Schedule K-1 setting out that partner’s share of the income, deductions, gains and losses, which the partner then reports on their own return. A REIT is different in kind. Its distributed taxable income avoids entity-level tax, but it is not a pass-through entity, so it cannot hand any tax loss to its shareholders. And the dividends it does pay are generally treated as ordinary income rather than at the reduced rates that apply to other corporate dividends.

Not every direct participation program is a partnership. The governing rule defines the category by flow-through tax consequences regardless of the legal entity, and one of the forms the outline names is tenancy in common. A tenant in common is deemed to own individually a physically undivided part of the whole parcel of property, not a share in a company or a partnership that owns it. Where investors pool money for a fractional interest in rental property and take their profit predominantly from the efforts of others, that interest is generally an investment contract and therefore a security, which brings the ordinary duties of suitability, due diligence, supervision and recordkeeping with it. The same three words — tenants in common — also name a way of registering a brokerage account, and they mean something different there.

Hedge funds restrict access to investors who meet the fund’s eligibility requirements. Those may involve financial resources, professional qualifications or other criteria. Read the offering terms, including the minimum investment and limits on withdrawals. Private does not mean free of securities law: antifraud rules still apply, and managers owe a fiduciary duty to the funds they manage.

Registration and listing are two separate questions for a REIT, and they give three kinds. A publicly traded REIT is registered with the SEC and listed on a stock exchange. A non-traded REIT is registered with the SEC but not listed, so it files reports and has a prospectus yet has no exchange market for its shares. A REIT can also be offered privately: its shares are sold in an offering exempt from registration, such as a Regulation D private placement, so it is neither registered nor listed and is generally sold to accredited investors. Registration tells you about disclosure; listing tells you whether there is an exchange where the shares can be sold.

Private equity is the other private fund the outline names. A private equity fund pools investors’ money under a private equity firm, which typically takes a controlling interest in an operating company and works to increase its value, or makes minority investments in fast-growing companies. The horizon is long, typically ten years or more, and the fund itself is not registered with the SEC even when its adviser is. It is usually open only to accredited investors and qualified clients, the initial investment is often very high, and the investment is often illiquid. A private equity fund is commonly organized as a partnership: the investor signs the fund’s agreements as a limited partner, and those agreements govern the fees, expenses and terms for the life of the fund.