Depreciation

A representative recommends an oil and gas DPP marketed heavily around its ability to generate depreciation and depletion deductions that shelter income for investors. The customer has very little taxable income and virtually no passive income from any source. What suitability concern does this raise, independent of the program's other features?

1. A.None, since tax-oriented deductions benefit every investor equally regardless of their income level or tax bracketWrong. A deduction-driven benefit is worth far less to a customer with little income to shelter and little passive income to absorb it.
2. B.An accredited investor concern only, since her limited income and lack of passive income are exclusively relevant to whether she qualifies for the offering under securities registration exemptionsWrong. This misidentifies the issue as an accreditation question rather than a suitability question about the value of the product's central benefit to her.
3. C.A liquidity-needs concern only, since her limited income means she cannot afford to have any of her capital tied up in an illiquid investmentWrong. This introduces an unsupported liquidity conclusion not raised by the facts given.
4. D.A concern that the program's principal advertised benefit, sheltering income through passive losses, has limited value to this specific customer, since she has little income to shelter and little passive income to absorb passive losses in the first placeCorrect. The program's central tax benefit has limited value to a customer with little income and little passive income to absorb the resulting losses.

Why: A deduction-driven benefit is worth much less to a customer with little income to shelter and little passive income to absorb the resulting passive losses, which is exactly the customer's profile here.

A land program bought unimproved acreage intending to resell it to a builder after rezoning. Rezoning has been delayed and the program still owes property taxes and interest on its acquisition loan. Where does the money to meet those obligations come from?

1. A.From the rents the program collects while it waits for the rezoning to come throughWrong. Unimproved acreage held for resale generates no rental stream to draw on.
2. B.From the depreciation deductions the acreage has generated since it was acquiredWrong. A deduction reduces taxable income and yields no cash, and raw land is not depreciated.
3. C.From reserves, from additional capital if the terms permit, or from a forced partial saleCorrect. With no revenue, the carry has to be met out of capital already raised or capital raised now.
4. D.From the escrowed portion of the offering proceeds, which must be released for this purposeWrong. This invents a mandatory release; escrow protects subscribers before a closing, not the sponsor afterwards.

Why: The outline pairs land development's appreciation potential with two risks: delay or failure to develop, and carrying costs with no cash flow. Those two combine badly, because taxes, insurance and interest keep accruing during exactly the period when the program has no revenue. A program in that position must fund the carry out of a working capital reserve set aside at the outset, out of further capital if the program's terms allow it to be called, or by selling part of the holding sooner and on worse terms than planned. An investor evaluating a land program should therefore study the size of the reserve and the assumed holding period as closely as the projected sale price.

An investor has two separate AMT preference items this year from two different DPPs: Item One is the excess of accelerated over straight-line depreciation on equipment, a difference expected to reverse over the asset's remaining life. Item Two is interest income from a private activity bond that is permanently exempt from regular tax but not from AMT. Which item is more likely to generate a minimum tax credit usable in a future year?

1. A.Item Two, because tax-exempt income is always treated as a timing item that eventually reversesWrong. Private activity bond interest is a permanent exclusion item for AMT purposes, not a timing item that reverses.
2. B.Both items generate an equally usable minimum tax credit, since both increase AMT in the current year by the same mechanismWrong. Raising current-year AMT the same way does not mean both items behave the same going forward; only the reversing item generates the credit.
3. C.Neither item generates a minimum tax credit, because minimum tax credits arise only from credits disallowed by the passive-activity rules, not from depreciation or interest preferencesWrong. This confuses the minimum tax credit with the separate passive-activity credit carryforward; depreciation timing preferences are a standard source of the minimum tax credit.
4. D.Item One, because it is a timing (deferral) difference that will reverse as regular-tax depreciation catches up, unlike Item Two's permanent exclusion from regular taxable incomeCorrect. The depreciation timing difference reverses over time and generates a minimum tax credit; the private activity bond interest is a permanent exclusion item that generally does not.

Why: A minimum tax credit arises from timing (deferral) preference items that reverse over time, such as the excess depreciation in Item One. Item Two is a permanent exclusion item with no future reversal, so it generally does not generate that credit.

A real estate program's accountant commissions a cost segregation study on a newly acquired apartment building. The study reclassifies a portion of the purchase price, previously treated as part of the building structure, into shorter-lived categories such as carpeting, certain electrical and plumbing components dedicated to specific fixtures, and parking-lot paving. What is the effect of this reclassification on the program's depreciation deductions, compared with depreciating the entire purchase price as building structure?

1. A.It has no effect on the timing of deductions; total depreciation over the life of the property is the same regardless of how the cost is categorized.Wrong. While the lifetime total may be similar, the timing shifts substantially, with deductions front-loaded into earlier years.
2. B.It converts what would have been depreciable building cost into a portion allocated to land, which is not depreciable at all.Wrong. The reclassified components remain depreciable; they are simply assigned to shorter-lived categories, not converted into non-depreciable land.
3. C.It is simply another way of describing the choice between an accelerated and a straight-line depreciation method on the same asset.Wrong. Componentizing the purchase price into separate asset categories is a different mechanism from choosing a depreciation method for a single asset.
4. D.It front-loads depreciation deductions, because the reclassified components recover their cost over shorter recovery periods than the building structure itself, producing larger deductions in the earlier years than would result from treating the entire cost as one long-lived building asset.Correct. Cost segregation shifts deductions earlier by assigning components to shorter recovery periods than the building shell.

Why: A cost segregation study breaks the purchase price into separate asset categories with their own, shorter recovery periods, front-loading depreciation deductions compared with treating the entire cost as one long-lived building asset.