DPPs, REITs, and Hedge Funds
About This Lesson
Direct participation programs, REITs, and hedge funds are the alternative investments on the SIE, products that sit outside ordinary stocks and bonds. They share a theme, pooling money into real estate or private ventures, but they differ sharply on the three things the exam cares about: who bears the risk, how the income and losses are taxed, and how easily an investor can get out. Keep those three axes in mind and the whole chapter organizes itself.
What you'll cover
- DPPs: the limited-partnership structure, pass-through taxation, the GP/LP split, and suitability
- REITs: equity versus mortgage, the qualification tests, and how they are taxed
- hedge funds: their strategies, the "2 and 20" fee structure, and the accredited-investor bar
- where each product falls on the liquidity spectrum
This is the eighth chapter of the products module.
Direct Participation Programs (DPPs)
A direct participation program (DPP) lets investors share directly in the cash flow and, just as importantly, the tax benefits of a business venture, almost always structured as a limited partnership. What sets a DPP apart from a corporation is that it is not taxed as a separate entity. A handful of features define it:
- Pass-through (flow-through) taxation: the program's income and losses flow straight through to the investors' own tax returns, the central appeal of the structure.
- Illiquidity: there is no real secondary market, so a DPP interest is hard to sell and is meant to be held for years.
- Limited partners are the passive investors, with liability capped at the amount they invest.
- The general partner runs the program and carries unlimited liability for its obligations.
DPPs come in several flavors, each with its own risk profile and its own tax deductions, and the SIE may ask you to recognize the common types:
- Oil and gas programs: ranging from high-risk exploratory (wildcat) drilling, through moderate-risk developmental wells, to lower-risk income programs that buy producing wells. They offer intangible drilling cost (IDC) deductions.
- Real estate limited partnerships: earn rental income from properties and pass through depreciation deductions.
- Equipment leasing programs: buy equipment and lease it to businesses, generating lease income plus depreciation.
- Agriculture programs: invest in crops or livestock, with returns that are seasonal and weather-dependent.
The split between the general partner and the limited partners is one of the most-tested ideas in this chapter:
| General Partner (GP) | Limited Partner (LP) | |
|---|---|---|
| Liability | Unlimited | Limited to investment |
| Management | Active, runs the business | Passive, NO management role |
| Binding authority | Can bind the partnership | Cannot bind the partnership |
| Minimum number | At least 1 required | None required (but typical) |
| Fiduciary duty | Yes, to the LPs | No |
The rule that trips people up: a limited partner who steps in and takes an active management role forfeits limited-liability protection and becomes exposed to unlimited liability, just like a general partner. Staying passive is what preserves the protection.
Before recommending a DPP (limited partnership), run through this filter:
1. High tax bracket? If not, the tax deductions are less valuable.
2. High net worth and income? DPPs are illiquid and high-risk.
3. Long time horizon? DPPs may be locked up for 10+ years.
4. NOT in a retirement account? Tax benefits are useless in IRAs/401(k)s.
If any of these fails, the DPP is likely unsuitable. The SIE will present scenarios where one of these factors is missing, choose "unsuitable" in that case.
A key feature of Direct Participation Programs (DPPs) is:
A limited partner in a DPP begins making day-to-day business decisions for the partnership. What is the consequence?
Which of the following investors would be LEAST suitable for a direct participation program (DPP)?
REITs
A real estate investment trust (REIT) pools investor money to own or finance real estate, giving ordinary investors a stake in large-scale property without buying buildings directly. REITs sort two ways. By what they hold:
- Equity REITs own and operate income-producing property and earn mostly rental income (the most common type).
- Mortgage REITs finance real estate and earn interest on the loans.
- Hybrid REITs do both.
And by how they trade, which drives their liquidity:
- Listed REITs trade on exchanges and are liquid.
- Non-listed REITs are registered but do not trade, so liquidity is limited.
- Private REITs are neither registered nor traded, the least liquid of all.
To qualify as a REIT and escape corporate-level tax, an entity has to clear a specific set of IRS tests:
- distribute at least 90% of taxable income to shareholders as dividends
- hold at least 75% of assets in real estate, cash, or U.S. Treasuries
- draw at least 75% of gross income from real estate sources (rents, mortgage interest, property sales)
- have at least 100 shareholders, with no more than 50% of shares held by five or fewer people (the "5/50 rule")
Meeting the 90% distribution test lets a REIT pass its income through and avoid double taxation. Note the asymmetry with a DPP: a REIT passes through income but not losses. And because that income is paid out from the trust level, REIT dividends are generally taxed as ordinary income rather than at qualified-dividend rates, though investors may still claim the 20% qualified business income (QBI) deduction.
To qualify as a REIT, an entity must distribute what minimum percentage of its taxable income to shareholders?
Hedge Funds
Hedge funds are private investment funds open only to accredited and institutional investors, and they sit at the aggressive, lightly regulated end of the spectrum:
- they require high minimum investments and are usually structured as limited partnerships
- they pursue aggressive strategies: leverage, short selling, and derivatives
- they are illiquid, often imposing lock-up periods that bar withdrawals for a stretch
- they face far less regulatory oversight than mutual funds, since they are sold privately under Reg D
Hedge funds are known for the "2 and 20" fee structure: a 2% annual management fee on assets plus a 20% performance fee on profits. A $1 million investment that earns a 30% return ($300,000 gain) would owe $20,000 in management fees plus $60,000 in performance fees, $80,000 in all.
Because hedge funds and many private placements sell under Reg D, they are limited to accredited investors. The SEC's definition includes:
- an individual with a net worth over $1 million, excluding the primary residence (alone or with a spouse)
- an individual with income over $200,000 in each of the two most recent years, or $300,000 jointly, with the expectation it continues
- certain institutions: banks, insurance companies, registered investment companies, and pension plans with over $5 million in assets
- directors, executive officers, or general partners of the issuer
- entities with total assets over $5 million
- holders of an active Series 7, 65, or 82 license (added in 2020)
A hedge fund manager charges a "2 and 20" fee structure. An investor contributes $1 million and the fund earns 30% in one year. What are the total fees?
Chapter Essentials
The three products here all sit outside the mainstream, for different reasons. DPPs (usually limited partnerships) pass both income and losses through to investors, are highly illiquid, and split roles between a general partner (manages, unlimited liability) and limited partners (passive, liability capped at their investment); an LP who starts managing loses that protection. REITs pass through income but not losses: clearing the 90%-distribution test (plus the 75% asset and income tests) lets them avoid corporate tax, and listed REITs trade on exchanges, far more liquid than DPPs.
Hedge funds are private, accredited-investor-only partnerships that use leverage, shorting, and derivatives, charge "2 and 20", and lock investors up. An accredited investor generally means $1 million in net worth (excluding the home) or $200,000 in income ($300,000 jointly). The throughline is liquidity: listed REITs are the most liquid of the group, DPPs the least.
Most Liquid → Least Liquid:
Listed REITs (exchange-traded) → Non-listed REITs → Hedge Funds (lock-up periods) → DPPs / Limited Partnerships (no secondary market, most illiquid)
The reliable gotchas in this chapter:
• DPPs pass through losses; REITs do not. Both are pass-through for income, but only a DPP sends losses to the investor's return. A REIT distributes income and avoids corporate tax, yet cannot pass losses through.
• A managing LP loses the shield. A limited partner who takes an active role in running the partnership forfeits limited liability and is exposed like a general partner. Staying passive is the whole point.
• 90% is the REIT number. A REIT must distribute at least 90% of its taxable income to avoid corporate-level tax, alongside the 75% asset and 75% income tests.
• DPPs are wrong for income and for IRAs. Illiquid and built around tax deductions, a DPP is unsuitable for someone needing current income, and its tax benefits are wasted inside a tax-deferred retirement account.
• "2 and 20" is 2% plus 20%. The 2% management fee is charged on assets and the 20% performance fee on profits, so a $1M account up 30% pays $20,000 + $60,000 = $80,000.
• Accredited means $1M or $200K. Net worth over $1 million excluding the primary residence, or income over $200,000 ($300,000 jointly) for two years, is the accredited-investor bar for hedge funds and Reg D deals.
Test yourself with exam-style questions on this topic.