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Let’s Try a Practice Question:
Which of the following statements regarding a REIT here is accurate?
- It is an investment vehicle that passes through gains and losses to investors
- It is a type of direct participation program (DPP) that gives investors access to a broad range of real estate assets
- It is a mostly illiquid investment that passes through losses to investors.
- It may be a publicly traded investment product that passes through income but not losses to investors
The answer here is 4.
How Do REITs Qualify for Favorable Tax Treatment?
REITs are very testable on the SIE exam. Importantly, what does the REIT need, how does it qualify for favorable tax treatment? The most important thing here to remember is that REITs are publicly traded, they pass through income, but they do not pass-through losses to investors. What’s the investment that passes through both? That’s going to be a Direct Participation Program (DPP). _
A DPP is an investment company that passes through both income and losses to investors. Think hedge funds, that are generally structured as pass-through entities, passing through both income and losses. REITs only pass-through income. What are the criteria that REIT must meet in order to be able to pass through that income? We are looking for a certain percentage here; 75, 75, 90. A REIT must have 75% of its income in real estate, 75% of its assets in real estate and 90% of the income must be distributed to shareholders. If you have all three of those characteristics, you do not pay any corporate income tax passed through to the investors and they just pay their ordinary income tax. Their shareholders are taxed directly.
What Are Direct Participation Programs?
They are an alternative structured product. They are not considered investment companies. A hedge fund is a good example of a direct participation program (DPP). The way to think about it is, it’s almost like you are directly participating in the actual business itself., Whether you are a limited partner or a general partner of a hedge fund, you are exposed to that business. Your risks are limited based on whether you are a limited partner or general.
Why Would an Investor Want to Offset their Passive Gains?
For starters, what does it mean to offset a gain, and would you only want to offset a loss? The answer here would be to reduce their taxes. If you have a big gain, say you do not want to pay taxes on that, you will find a loss to help cover that. In fact, if you have brokerage accounts, or if you trade stocks, you can reduce the taxes that you will pay on profits, on the sale of any of your stocks, all by taking a few losses on other investments you have.
