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
| Feature | Description |
|---|---|
| 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)
| Role | Description |
|---|---|
| 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)
| Role | Description |
|---|---|
| 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
| Item | Benefit to Investor |
|---|---|
| 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
| Factor | DPPs | Corporations |
|---|---|---|
| Entity-level tax | None | Yes (double taxation) |
| Loss pass-through | Yes | No |
| Income pass-through | Yes | Only when dividends paid |
| Tax benefits | Flow to investors | Stay at corporate level |
DPPs vs. REITs
| Factor | DPPs | REITs |
|---|---|---|
| Pass-through income | Yes | Yes |
| Pass-through losses | Yes | No |
| Liquidity | Low | High (if traded) |
| Typical investor | Accredited | 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)
| Feature | Description |
|---|---|
| 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
| Program Type | Risk Level | Description |
|---|---|---|
| Income (Stripper) wells | Lowest | Producing wells with established reserves |
| Developmental | Moderate | Drilling near proven reserves |
| Exploratory (Wildcat) | Highest | 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 | Not Suitable If |
|---|---|
| Have passive income to offset | Need liquidity |
| High tax bracket | Low tax bracket |
| Long-term investment horizon | Need current income |
| Accredited investor status | Cannot afford total loss |
| Understand the risks | 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
| Risk Type | Description |
|---|---|
| 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
A key difference between DPPs and REITs is that DPPs:
In a limited partnership DPP, which partner has unlimited liability?
Losses from a DPP can be used to offset which type of income?
2.18 Systematic Risk
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