Module 3 — Products and Their Risks · Lesson 3.6
REITs, DPPs and Private Funds
The products outside the ordinary wrappers, and what that costs the investor
~9 min
What you'll learn
- Describe a REIT's structure, types and distribution requirement
- Explain why a REIT is not a direct participation program
- Describe the limited partnership structure and flow-through taxation
- Identify a hedge fund's characteristics and the investor standards that apply
Each product here gives up something a mutual fund provides — daily liquidity, standardized disclosure, or restrictions on leverage — in exchange for access to an asset class or a strategy. The exam's interest is almost entirely in what was given up.
Real estate investment trusts
A REIT is a company that owns and usually operates income-producing real estate, or lends against it, giving investors exposure to commercial property in a divisible form.
To qualify as a REIT, a company must meet asset and income tests centred on real estate and must distribute at least 90 percent of its taxable income to shareholders each year. In exchange it deducts those distributions and avoids corporate-level tax on them.
The distinction the exam tests most often: a REIT is a conduit in one direction only. Income flows through to shareholders; losses do not. A REIT cannot pass depreciation losses to its shareholders, which is precisely what a direct participation program can do — so a REIT is not a DPP.
Three types. An equity REIT owns properties and earns rents, and is most of the market. A mortgage REIT holds mortgages and mortgage-backed securities and earns interest, which makes it interest-rate sensitive in a way an equity REIT is not. A hybrid REIT does both.
Distributions are generally taxed as ordinary income rather than as qualified dividends, because the REIT paid no corporate tax on them.
A listed REIT trades on an exchange. A non-traded REIT does not, and that is where the risk concentrates: there is no secondary market, the price on a customer statement is a sponsor estimate rather than a market price, front-end costs can consume a substantial share of the investment, and distributions may be funded from offering proceeds or borrowings rather than from operations — which means the customer is receiving their own money back and being told it is a yield.
Direct participation programs
A direct participation program passes income, gains, losses, deductions and credits directly to the investor rather than trapping them inside a corporation. Most are limited partnerships.
The general partner manages the program, makes the decisions and has unlimited personal liability. Limited partners contribute capital, have no management role, and have limited liability — confined to their investment. That protection is conditional: a limited partner who takes an active role in management risks being treated as a general partner and losing it.
A partnership pays no entity-level tax. Each partner receives a Schedule K-1 and reports their share on their own return. But a limited partnership interest is a passive activity, so passive losses may generally be deducted only against passive income, not against wages or investment income. Unused losses are suspended and carried forward.
The program types: real estate, which generates depreciation deductions; oil and gas, where exploratory programs carry the most risk and the most front-loaded deductions through intangible drilling costs, and income programs buy producing wells; and equipment leasing.
The evaluation rule the exam wants: economic soundness comes first. A program must make sense as a business before its tax treatment matters, and a representative recommending one for its tax losses to a customer with no passive income has misrepresented what the customer will get.
On dissolution, claims are satisfied in order: secured lenders, general creditors, limited partners, general partners.
Hedge funds and private funds
A hedge fund is a privately offered pooled vehicle relying on an exclusion from the definition of investment company under the 1940 Act. Because it is not a registered investment company, it is not bound by the Act's limits on leverage, short selling, concentration or liquidity, and it can pursue strategies a mutual fund cannot.
What that costs the investor is the set of characteristics the exam names: interests are sold in a private placement, generally to accredited investors and often to a higher standard; liquidity is limited or absent, with lock-up periods and restricted redemption windows; information is limited and there is no standardized prospectus; and charges are high, typically a management fee plus a performance allocation.
'Hedge fund' describes a legal structure, not a risk profile. Two hedge funds can pursue opposite strategies with entirely different risk.
A fund of funds invests in other hedge funds, adding manager diversification and a second layer of fees.
An accredited investor is defined by SEC Rule 501: a natural person with a net worth over $1,000,000 excluding the primary residence, or income over $200,000 individually or $300,000 jointly in each of the two most recent years with a reasonable expectation of the same; certain professional credential holders, including holders of the Series 7, Series 65 and Series 82 in good standing; and specified institutions.
Do not confuse that with a qualified institutional buyer, which under Rule 144A is an institution owning and investing at least $100 million in securities — never a natural person.
Key takeaways
- ·A REIT must distribute at least 90 percent of taxable income; income flows through but losses do not, so a REIT is not a DPP.
- ·Non-traded REITs have no secondary market, sponsor-estimated valuations, heavy front-end costs, and distributions that may not come from operations.
- ·In a limited partnership the GP manages with unlimited liability; the LP's limited liability depends on staying out of management.
- ·DPP losses are passive and deductible only against passive income; evaluate economic soundness before tax benefits.
- ·Hedge funds trade regulation for illiquidity, opacity and high fees; accredited investors can be individuals, QIBs never are.
The module closes with the risks that run across every product in it.
Sources
- 1.Securities Industry Essentials (SIE) Examination Content Outline
Financial Industry Regulatory Authority (FINRA) · 2025
Sections 2.1.6 to 2.1.8 cover direct participation programs, real estate investment trusts and hedge funds, including their structures, liquidity characteristics and investor eligibility.
- 2.26 U.S. Code § 856 — Definition of real estate investment trust
U.S. Congress · Legal Information Institute, Cornell Law School
The asset, income and organizational tests a company must satisfy to be taxed as a REIT.
- 3.Real Estate Investment Trusts (REITs)
Securities and Exchange Commission, Office of Investor Education and Advocacy · Investor.gov glossary
REIT structure and the liquidity and valuation risks that distinguish a non-traded REIT from a listed one.
- 4.17 CFR 230.501 — Definitions and terms used in Regulation D
Securities and Exchange Commission · Electronic Code of Federal Regulations
The accredited investor definition, including the net worth and income tests and the professional credential category.