Diversifying With Direct Investments. To discuss your personal financial needs, please contact: enter contact information here

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1 Diversifying With Direct Investments To discuss your personal financial needs, please contact: enter contact information here

2 1. Name the risk factors you must disclose when discussing limited partnerships with clients (choose one or more) a. Lack of liquidity b. Lack of control c. Credit risk d. Tax risk e. Investment risk f. All of the above Answer: a, b, d, and e Limited partnerships entail special risks beyond the risks associated with stock or bond investing. These risks must be made clear to any prospective client. These include: lack of liquidity, lack of control, and tax risk (the risk of paying taxes on phantom income). Additionally, limited partnerships involve investment risk liquidity risk the risk that the investment will lose value just like any other investment. Credit risk, or the risk that a borrower will default on a payment, is generally associated with bonds, not limited partnerships. 2. An accredited investor: a. Has a net worth of $2 million and annual income of at least $200,000. b. Has investible assets of at least $1 million and annual income of at least $200,000. c. Has a net worth of at least $1 million (excluding the value of his or her primary residence) and annual income of at least $200,000. d. Has total assets of at least $1 million and annual income of at least $300,000. e. Has investible assets of $2 million and annual income of at least $200,000. Answer: c Under the SEC s Regulation D, to be eligible to purchase units of certain private limited partnerships, an investor must be accredited he or she must have a net worth of at least $1 million (excluding the value of his or her primary residence) and annual income of at least $200,000 ($300,000 for a joint filer) in each of the last two years. Other restrictions also apply.

3 3. What one feature distinguishes direct investments most from indirect investments? a. Their lack of liquidity b. The pass through of income and losses to investors c. Their direct ownership structure of the underlying assets d. The limited liability of investors e. The higher risk associated with direct investments Answer: b The principal factor differentiating direct investments from indirect investments such as stocks is their ability to pass through income and losses directly to investors without having to pay tax at the entity level. 4. A master limited partnership is: a. A partnership that serves as general partner of a limited partnership. b. A partnership that has more than 35 investors and is registered with the SEC. c. Another name for a REIT that is traded on the secondary market. d. A partnership whose units trade on a major exchange. e. A corporate partnership that sponsors limited partnerships. Answer: d A master limited partnership (MLP) is a type of limited partnership that offers liquidity by being traded on a major exchange such as the New York Stock Exchange. MLPs must also meet other specifications to qualify under SEC rules.

4 5. In gauging whether a given limited partnership is suitable to a given investor, which of the following factors should be taken into consideration (choose one or more)? a. The investor s net worth and annual income b. The tax structure of the investment c. The investor s tax situation d. The specifics of the underlying investment e. The investor s other investments f. All of the above Answer: f To assess the suitability of a limited partnership for a specific investor, you need to weight multiple factors. You should consider the client s net worth, income, tax status and needs, appetite for risk, and ability to hold the investment until its liquidation. At the same time, you ll need to consider how well the structure, terms, and timing of the investment mesh with the client s needs, as well as the viability of the underlying investment. 6. The Passive Activity Loss rules state that: Passive income must exceed passive income over the life of the investment. Passive losses are limited to $3,000 per year per individual. Passive losses can only be used to offset passive income. Losses from passive activities may be used to offset long-term capital gains. Passive losses may not exceed passive income in any given tax year. Answer: c The Passive Activity Loss rules state that any losses from passive activities may be used only to offset income from other passive activities. Before 1986, passive losses could be used to offset any income, a feature that led to the widespread abuse of partnerships as tax shelters. There is no limit to the amount of passive losses one can claim in a given year, provided these losses are used to offset other passive income (although exceptions may apply for passive losses associated with actively managed rental property).

5 7. Phantom income represents: a. Income from passive activities that cannot be offset by losses. b. Income that is taxable at the investor level but not at the entity level. c. Passive income that is reportable as a capital gain. d. Income that is taxable but not actually received. e. Income that is received through cash distributions. Answer: d Phantom income occurs when a partnership earns a profit and allocates the net income to its partners, but does not actually distribute that income. Limited partners pay taxes on their allocated share of partnership income not on actual cash distributions. This can be a significant issue, especially if the partnership undergoes a restructuring or debt refinancing that results in a significant paper gain. 8. Which of the following features apply to a public limited partnership (choose one or more)? a. Units are traded on a secondary market b. Registered with the SEC c. More than 35 partners d. Limited to accredited investors e. Issue a prospectus f. All of the above Answer: b, e Public partnerships are distinguished from private partnerships in that they are required to register with the SEC, they issue an offering prospectus, and they are required to submit annual and quarterly reports to the SEC. Public partnerships are not restricted to a minimum number of investors. A private partnership can have no more than 35 limited partners, issues an offering memorandum, may or may not be required to register with the SEC and report on its operations, depending on its structure and other criteria), and is limited to accredited investors. Public partnerships do not necessarily trade on a secondary market.

6 9. Which of the following does NOT apply to a real estate investment trust (REIT)? a. Must pass through at least 90% of its income to investors b. Trades on a major exchange c. Invests in different types of commercial real estate d. Comes in three types: equity, mortgage, and hybrid e. Primary investment objective is long-term capital gains Answer: e REITs fall into the direct investment classification because they must pass through at least 90% of their income, or funds from operations, to investors. Unlike other direct investments, REITs trade on a major exchange and are highly liquid. They invest in different types of commercial real estate and come in three different structures: equity, mortgage, and hybrid. REITs are usually purchased for their income potential not their capital appreciation although some investors may buy them for that reason.

7 10. Hector is a successful 45-year-old car salesman who is looking to diversify his $750,000 portfolio. He earns an annual income of approximately $180,000 and is risk tolerant. He has several other passive investments that collectively generate a net loss. His long-term investment goal is to aggressively grow his portfolio until his planned retirement at age 60, but may look to cash in a portion in 10 years when his son reaches college age. Hector is considering investing $25,000 in one of the following limited partnerships. Which is the most suitable choice? a. ACE, LP is a partnership that invests in construction equipment, then leases out the equipment to major contractors. This public partnership is expected to generate annual income over its projected life of 10 years, and a significant gain from the eventual sale of the equipment. There is no secondary market for units at present. b. Dealers, LP is a limited partnership that finances the construction and operation of auto dealerships. It is a public partnership, with no secondary market for units. It is expected to generate tax losses, then generate a gain upon sale of the properties and dissolution of the partnership in 7-10 years. a. Malls, LP is a master limited partnership that owns and operates three malls in California. The partnership is projected to provide steady income and cash distributions over its projected year life. a. Hollywood, LP is a private partnership that invests in 10 feature films produced by major Hollywood studios. The partnership is expected to generate tax losses during the first five years, then steady income and cash distributions during the final five years of its projected 10year life. b. None of the above is suitable for Hector who is not an accredited investor. Answer: a Hector s investible assets and income are insufficient to qualify him as an accredited investor, so he would be ineligible to participate in the private partnership, Hollywood, LP. But he may qualify for the others. While Dealers, LP would appear to be right up his alley, this partnership is expected to generate tax losses, which Hector already has more of than he can use. Malls, LP might also be a good fit due to its liquidity as a master LP, except for its long projected life. This leaves ACE, LP as the most suitable choice, since it generates income that Hector can use to offset his losses, and is expected to have an eventual gain on sale of equipment, which ties in with his long-term investment goals.