2.17 DPPs

Direct Participation Programs (DPPs)

Direct Participation Programs (DPPs) are investments that allow income, gains, losses, and tax deductions to "flow through" directly to investors. They are typically structured as limited partnerships and are often used for real estate, oil and gas, and equipment leasing investments.

What Is a DPP?

A Direct Participation Program (DPP) is an investment vehicle that passes through income, gains, losses, and tax benefits directly to investors without being taxed at the entity level.

Key DPP Characteristics

Tax treatment: Flow-through (pass-through) taxation

Structure: Usually limited partnerships

Losses: Can be passed through to investors

Liquidity: Generally illiquid

Suitability: Typically for accredited investors

DPP Structure: Limited Partnerships

Most DPPs are organized as limited partnerships with two types of partners:

General Partner (GP)

Management: Runs day-to-day operations

Liability: Unlimited personal liability

Compensation: Management fees and share of profits

Decision-making: Full control over business

Limited Partners (LPs)

Investment: Provide capital

Liability: Limited to investment amount

Management: Cannot participate in management

Tax benefits: Receive flow-through of income and losses

Key Point: Limited partners must remain passive. If they participate in management, they may lose their limited liability protection.

Flow-Through Tax Treatment

The most important feature of DPPs is their flow-through taxation:

What Flows Through

Income: Taxable as ordinary income

Gains: Taxable as capital gains

Losses: Deductible against passive income

Deductions: Depreciation, depletion, interest

Tax credits: Dollar-for-dollar tax reduction

DPPs vs. Corporations

Entity-level tax: DPPs - None; Corporations - Yes (double taxation)

Loss pass-through: DPPs - Yes; Corporations - No

Income pass-through: DPPs - Yes; Corporations - Only when dividends paid

Tax benefits: DPPs - Flow to investors; Corporations - Stay at corporate level

DPPs vs. REITs

Pass-through income: DPPs - Yes; REITs - Yes

Pass-through losses: DPPs - Yes; REITs - No

Liquidity: DPPs - Low; REITs - High (if traded)

Typical investor: DPPs - Accredited; REITs - Any

Important: REITs pass through income only. DPPs pass through both income AND losses - this is a key distinction for the exam.

Types of DPPs

Real Estate Limited Partnerships (RELPs)

Investment: Commercial or residential properties

Income: Rental income

Tax benefits: Depreciation, mortgage interest deductions

Special credits: Historic rehabilitation, low-income housing

Oil and Gas Programs

Income (Stripper) wells: Lowest risk; Producing wells with established reserves

Developmental: Moderate risk; Drilling near proven reserves

Exploratory (Wildcat): Highest risk; Drilling in unproven areas

Tax Benefits of Oil and Gas DPPs:

- Intangible Drilling Costs (IDCs): Immediately deductible expenses (wages, fuel, supplies)

- Depletion Allowance: Tax deduction as resources are extracted

- Tangible Drilling Costs: Depreciated over time (equipment, structures)

Equipment Leasing Programs

- Purchase equipment and lease to businesses

- Generate income from lease payments

- Tax benefits from depreciation

Suitability Considerations

DPPs are suitable for investors who:

Suitable If: Have passive income to offset; High tax bracket; Long-term investment horizon; Accredited investor status; Understand the risks

Not Suitable If: Need liquidity; Low tax bracket; Need current income; Cannot afford total loss; Risk-averse

Passive Activity Loss Rules

IRS passive activity rules restrict how DPP losses can be used:

- DPP losses can only offset passive income

- Passive income includes: rental income, other DPPs

- Cannot offset wages, portfolio income, or active business income

- Unused losses carry forward to future years

Example: An investor with $50,000 in salary income and a $20,000 DPP loss cannot use the loss to reduce current taxes unless they have passive income from other sources.

Risks of DPPs

Illiquidity: No active secondary market

Business risk: Project may fail

Economic risk: Market conditions may deteriorate

Tax law changes: Tax benefits may be reduced

General partner risk: GP may mismanage

Key Takeaways

- DPPs pass through income, gains, losses, AND deductions to investors

- Most are structured as limited partnerships

- General partners manage; limited partners are passive investors

- Losses can only offset passive income (IRS restriction)

- Oil and gas programs offer IDC deductions and depletion allowances

- DPPs are illiquid and suitable primarily for accredited investors

- Key difference from REITs: DPPs can pass through losses