What it means
In a DPP, a sponsor organises a partnership and raises money from investors. Investors become limited partners, which means they put in capital but do not run the business and their possible loss is generally limited to what they invested.
The sponsor, as general partner, manages the project and makes the decisions. The key feature is pass-through treatment.
The partnership itself usually does not pay income tax, and instead each partner reports their share of income, gains, losses and deductions on their own tax return. This can be attractive when the project produces large deductions, such as depreciation on buildings or drilling costs in the early years.
Common examples include real estate partnerships that buy apartment blocks or offices, oil and gas programs that fund wells, and equipment leasing partnerships that buy aircraft or machinery. Investors receive cash distributions as the project generates income, and they may receive a final payout when assets are sold.
DPPs carry significant risks. Units are generally illiquid, meaning they cannot be sold easily, and investors may be locked in for many years.
Fees can be high, the project may fail, and passive loss rules in many tax systems limit the use of losses against other income. Tax rules on losses and deductions are complex and change from time to time, so a professional adviser is essential.
Regulators in some countries treat these products as complex and restrict their sale to investors who meet minimum income or net worth tests. Anyone considering a DPP should read the offering documents, understand the sponsor's track record and fees, and check how and when cash will be returned.
They should also model the after-tax return instead of relying only on the headline distribution rate. A well-run programme can provide diversification, while a poorly run one can lock up capital for years.
In practice
Real-world examples.
Example
An investor buys 100 units in a limited partnership that owns three apartment buildings. Each year she receives a statement showing her share of rental income and depreciation. She reports these figures on her own tax return.
Example
A wealthy individual invests $50,000 in an oil and gas drilling program to gain exposure to energy. The partnership spends heavily on drilling in its first year and generates large deductions. He understands that the wells could produce nothing and that he could lose the entire amount.
Example
A financial adviser reviews a client's request to put $200,000 into an equipment leasing partnership. She explains that the units are hard to sell and that the client may not get access to the money for ten years. The client reduces the amount to $50,000.
Formula
Calculation
Investor's share of partnership income = (Units held / Total units) x Partnership taxable income
Worked example: a real estate partnership has 1,000 units in total, and an investor holds 50 units. The partnership earns taxable income of $400,000 in the year.
Step 1: Ownership share = 50 / 1,000 = 5%
Step 2: Investor's share of income = 5% x $400,000 = $20,000
The investor reports $20,000 of income on their own tax return, whether or not the partnership actually distributes that much in cash.Case study
Seen in the real world.
Stonebridge Partners is an illustrative, fictional sponsor that raised $10,000,000 from 200 investors to buy a small office building through a limited partnership. Each unit cost $10,000, so there were 1,000 units in total.
In the first year, the building generated rental income of $900,000 and operating expenses and depreciation of $700,000, leaving taxable income of $200,000. An investor holding 20 units, a 2% share, was allocated $4,000 of taxable income.
The partnership distributed $3,000 in cash to that investor and the rest was retained for repairs. The illustrative lesson is that investors can owe tax on their allocated share of income even if the cash received is lower.
Watch out
Common mistakes.
- Assuming a DPP works like a stock, when units are usually illiquid and cannot be sold quickly.
- Focusing on tax deductions alone, when the underlying project must be sound to earn a return.
- Forgetting that income can be taxable even if no cash is distributed, when profits are allocated to partners each year.
Questions
People also ask.
What does limited partner mean?
A limited partner provides capital but does not manage the business, and the possible loss is generally restricted to the amount invested.
Who can invest in a DPP?
Rules vary, and many programs require investors to meet minimum income or net worth standards because of the risks.
How is a DPP taxed?
The partnership usually passes income, gains, losses and deductions through to partners, who report them on their own tax returns.
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