An investor owns shares of a publicly traded equity REIT in a taxable brokerage account. During the year the REIT distributes $1.50 per share, consisting of $0.90 of ordinary dividend income, $0.40 of long-term capital gain, and $0.20 of return of capital. The investor's cost basis is $25 per share.
Which statement is correct regarding the tax treatment of this distribution? Answer: The investor reports $0.90 of ordinary income and $0.40 of long-term capital gain; the $0.20 return of capital reduces the basis to $24.80.
REIT tax treatment under IRC §§ 856-857. A REIT distribution is taxable to the shareholder in the character of the income the REIT earned: ordinary income at ordinary rates, a designated capital gain dividend at long-term capital gain rates, and a return of capital not currently taxable but reducing the shareholder's basis. The investor therefore reports $0.90 of ordinary income and $0.40 of long-term capital gain, and reduces the $25 basis by the $0.20 return of capital to $24.80. The statement that all $1.50 is ordinary income ignores the capital-gain designation and the return of capital. The statement that $1.30 is all ordinary income mischaracterizes the $0.40 capital gain, which is taxed at capital-gain rates. The statement that only the $0.90 is currently taxable is wrong because the $0.40 capital gain distribution is taxable in the year received.
An investment adviser wishes to charge a performance fee to a new investor in a private fund. The investor is a single individual who will have $1,350,000 under management with the adviser immediately after the investment, has a net worth of $2,600,000 excluding a primary residence, and had annual income of $230,000 in each of the last two years with the same expected this year.
Which of the following statements is correct? Answer: The investor is an accredited investor but not a qualified client, so the adviser may not charge a performance fee.
Investment Advisers Act Rule 205-3 permits a performance fee only with a qualified client. A qualified client is an individual with at least $1,400,000 under management with the adviser immediately after entering the contract, or with a net worth above $2,700,000 excluding the primary residence. This investor meets neither test: $1,350,000 is below $1,400,000, and $2,600,000 is below $2,700,000. The investor does meet the accredited investor income test — $230,000 exceeds the $200,000 single-filer threshold — but accredited investor status under Regulation D is not the qualified client standard. The statement that the accredited income test makes the investor a qualified client applies the wrong test, and the statement that the two amounts can be combined against a $3,000,000 aggregate threshold invents a test the rule does not contain. The statement that the investor is not an accredited investor is wrong because the income test is satisfied.
Under the Investment Company Act, a fund relying on Section 3(c)(7) may have as beneficial owners only 'qualified purchasers'; an individual is a qualified purchaser only if he owns at least $5,000,000 in investments. A Section 3(c)(7) hedge fund proposes to admit an accredited investor who owns $3,000,000 in investments and has a net worth of $6,000,000, excluding his primary residence.
Which statement is correct? Answer: The investor may not be admitted, because the qualified purchaser test is based on investments owned, and he owns only $3,000,000.
Investment Company Act § 2(a)(51) and § 3(c)(7). Under the facts presented, a fund relying on Section 3(c)(7) must have only qualified purchasers as beneficial owners. For an individual, the qualified-purchaser test is ownership of at least $5,000,000 in investments; net worth is not the test. Because this investor owns only $3,000,000 in investments, he does not meet the qualified-purchaser threshold and may not be admitted to this Section 3(c)(7) fund. Accredited-investor status under Regulation D is a separate, lower standard and does not make him a qualified purchaser. The numerical 100-beneficial-owner limit applies to Section 3(c)(1) funds, not Section 3(c)(7) funds; Section 3(c)(7) instead limits beneficial owners to qualified purchasers.
A hedge fund charges a 1.5% management fee, calculated on the fund's assets at the beginning of the year, and a 20% incentive fee on the year's gain above the fund's high-water mark, computed after deducting the management fee. The fund's high-water mark is $120 per share. The per-share NAV at the beginning of the year is $100, and the year-end NAV before any fees is $115.
What is the investor's approximate net return for the year? Answer: 13.5%
Hedge fund fee structure — a management fee plus an incentive fee subject to a high-water mark. The management fee is 1.5% of the $100 beginning NAV, or $1.50 per share. The year-end NAV after the management fee is $113.50. Because $113.50 is below the $120 high-water mark, no incentive fee is earned. The net return is 13.5%: ($113.50 - $100) / $100 = 0.135. The 15.0% figure ignores both fees. The 10.8% figure charges a 20% incentive fee on the $13.50 net gain above the year-start NAV, wrongly substituting the beginning NAV for the high-water mark. The 10.5% figure charges 20% on the $15 gross gain, applying the incentive fee to the gross return and the wrong benchmark.
- Which statement correctly describes a difference between a hedge fund and a private equity fund?
Answer: Hedge funds may use leverage, short sales, and derivatives for absolute returns, while private equity funds take long-term stakes in operating companies.
Investment Company Act §§ 3(c)(1) and 3(c)(7), and the operating characteristics of private funds. Hedge funds typically trade liquid securities, may use leverage, short sales, and derivatives, and offer periodic redemptions; private equity funds raise committed capital to acquire significant or controlling stakes in operating companies and hold them over a multiyear fund term with no redemption rights. The statement that reverses those redemption features misstates both vehicles. The 90% annual distribution requirement is a REIT tax rule and does not apply to private equity funds. Private funds rely on the 3(c)(1) or 3(c)(7) exemption and are not registered investment companies, so the open-end/closed-end distinction does not describe them.
A REIT distributes $5.00 per share to its shareholders. The distribution consists of $3.00 of ordinary rental income, $1.00 that the REIT designates as a long-term capital gain dividend from the sale of a property, and $1.00 that exceeds the REIT's current and accumulated earnings and profits. The shareholder's cost basis in the REIT shares is greater than $1.00 per share.
Which of the following statements regarding the shareholder's tax treatment is true? Answer: The $3.00 is ordinary income, the $1.00 capital gain dividend is taxed at long-term rates, and the $1.00 excess is a return of capital reducing cost basis.
Under the Internal Revenue Code provisions governing REITs (IRC §§ 856-857), a REIT is generally allowed a dividends-paid deduction, so distributed income is not taxed at the REIT level, and the character of the distribution carries through to the shareholder. The $3.00 rental-income portion is taxable as ordinary income. The $1.00 designated capital gain dividend is taxable to the shareholder at long-term capital gains rates. The $1.00 distribution exceeding the REIT's current and accumulated earnings and profits is a return of capital and reduces the shareholder's cost basis. The statement that the entire $5.00 is ordinary income is wrong because a REIT may designate a capital gain dividend. The statement that the $2.00 balance is tax-free because the REIT already paid tax on the gain is wrong on both counts: the capital gain dividend is taxable to the shareholder, and the REIT does not pay entity-level tax on distributed income. The statement that the entire $5.00 is a tax-free return of capital is wrong because only the portion exceeding earnings and profits is a return of capital; the rest is taxable to the shareholder.
A pension plan has committed $15,000,000 to a private equity fund with a 10-year term. Before the full commitment has been called, the plan asks the general partner to release it from the unfunded portion.
Under the standard structure of a private equity fund commitment, which statement is correct regarding the plan's request? Answer: The unfunded commitment is binding; the fund may issue capital calls during the commitment period, and the plan cannot unilaterally withdraw from it.
Private equity fund partnership structure. A limited partner makes a binding capital commitment and funds it over time as the general partner issues capital calls; the unfunded commitment remains an obligation of the partner and generally cannot be unilaterally withdrawn or redirected. The statement that the full commitment is due at formation misstates the drawdown process. Directing the general partner to stop issuing capital calls is not a limited partner's right under the standard partnership agreement. A mandatory return of unused commitments with interest after three years is not a standard fund term; any return of uninvested capital is governed by the partnership agreement, not an automatic interest-bearing obligation.
A client, age 58, expects to retire in 12 years and has a moderate risk tolerance. She wants to add an alternative investment to her diversified portfolio, and she wants current income, some inflation protection, and long-term growth. She insists on being able to liquidate the investment without restriction at any time. She is an accredited investor and has a fully funded emergency reserve.
Which of the following alternative investments is most suitable for this client? Answer: An exchange-traded equity REIT with a 4.5% distribution yield and a long history of increasing its dividend each year.
Client suitability analysis and the income, liquidity, and time-horizon characteristics of the alternative vehicles. The client needs current income, inflation protection, long-term growth, and unrestricted liquidity. An exchange-traded equity REIT provides quarterly distributions funded by rental income, real-estate-based inflation protection, appreciation potential, and daily market liquidity, so it satisfies every stated need. The non-traded REIT pays a higher target yield, but its redemption cap conflicts with the client's insistence on being able to liquidate without restriction. The private equity buyout fund distributes no current income and locks up the investment for the fund's term. The market-neutral hedge fund provides no stated current income, and quarterly redemptions do not meet the client's requirement of being able to liquidate without restriction at any time.
To maintain its status as a REIT, a company must distribute at least 90% of its taxable income each year. This year a REIT has taxable income of $2,000,000 and distributes $1,800,000 to its shareholders.
Which statement is correct about the federal income tax treatment of the REIT and its distribution? Answer: The distributed $1,800,000 is not taxed at the entity level, but the $200,000 retained is taxed to the REIT at corporate rates.
IRC §§ 856-857. The 90% distribution test is a qualification requirement, not a tax holiday: a REIT deducts the dividends it actually pays, and any income it retains is taxed at the entity level at corporate rates. Because the REIT distributed exactly 90% of its $2,000,000 taxable income, it keeps its REIT status, but the retained $200,000 is subject to corporate income tax. The statement that the REIT loses pass-through status for retaining 10% misstates the requirement, since 90% is the required minimum. The statement that satisfying the 90% test exempts the retained income from tax confuses qualification with taxation. The statement that the income escapes taxation at both levels ignores the entity-level tax on the retained $200,000 and the shareholders' tax on the distribution they receive.
- A client asks an IAR about public non-traded REITs. Which statement is correct?
Answer: Public non-traded REITs are SEC-registered but not exchange-listed, so their shares are illiquid and difficult to sell.
Securities Act of 1933 registration requirements and IRC § 857. A public non-traded REIT's shares are registered with the SEC, but they are not listed on a national securities exchange; liquidity is generally limited to the sponsor's redemption program, which may impose caps and waiting periods. The statement that such REITs are unregistered private placements describes a private REIT offered under Regulation D, not a public non-traded REIT. The 90% taxable-income distribution requirement applies to all REITs, whether or not their shares are exchange-listed. Daily NAV pricing with unlimited daily redemptions describes an open-end investment company, not a non-traded REIT.
- A Section 3(c)(1) fund (other than a qualifying venture capital fund) may have no more than 100 beneficial owners. Which of the following statements regarding private funds that rely on Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act of 1940 is true?
Answer: A Section 3(c)(1) fund is limited to 100 beneficial owners and may not make a public offering, while a Section 3(c)(7) fund is not subject to a numerical owner limit and may sell only to qualified purchasers.
Section 3(c)(1) of the Investment Company Act of 1940 excludes from the definition of an investment company an issuer whose outstanding securities are beneficially owned by no more than 100 persons and that is not making and does not propose to make a public offering. Section 3(c)(7) excludes an issuer whose outstanding securities are owned exclusively by qualified purchasers and that is not making a public offering; it has no numerical owner cap. The correct statement is therefore that a 3(c)(1) fund is limited to 100 beneficial owners and may not make a public offering, while a 3(c)(7) fund has no numerical owner limit and sells only to qualified purchasers. The statement limiting a 3(c)(7) fund to 100 qualified purchasers wrongly imports the 3(c)(1) owner count into the 3(c)(7) exclusion. The statement that a 3(c)(1) fund may accept unlimited accredited investors plus up to 35 non-accredited investors in any 90-day period confuses the Rule 506(b) private-placement purchaser limit with the fund's own 100-beneficial-owner cap. The statement that either fund must register under the 1940 Act once owners exceed 500 is wrong: a fund that continues to satisfy Section 3(c)(1) or Section 3(c)(7) is not an investment company under the Act and does not register under it; exceeding 500 owners is not the point at which registration would arise.
An exempt reporting adviser relies on the private fund adviser exemption and files exempt reporting reports with the SEC and the states. It manages a single private fund that relies on Section 3(c)(1) of the Investment Company Act; the fund is not a venture capital fund, and the adviser has no bad-actor events. A prospective investor has a net worth of $2,300,000 excluding his primary residence and $350,000 of annual income, and has no assets under management with the adviser. The adviser will provide the disclosure document and annual audited financial statements required by the NASAA model rule.
Under the NASAA model rule adopted by the state, may the adviser admit the investor to the fund? Answer: No, because this non-venture Section 3(c)(1) fund may admit only qualified clients, and the investor satisfies neither qualified-client test.
NASAA model rule for exempt reporting advisers, read with IAA § 203(m) and SEC Rule 205-3. Under the model rule, an adviser relying on the private fund adviser exemption that sponsors a Section 3(c)(1) fund that is not a venture capital fund may admit only qualified clients, with disclosure and annual audited financials. The qualified-client tests are $1,400,000 of assets under management with the adviser immediately after the contract or a net worth above $2,700,000 excluding the primary residence. The adviser's disclosure and audited-financials conditions are satisfied, but the investor has no assets under management with the adviser and a net worth of only $2,300,000, so he is not a qualified client; his accredited-investor status and $350,000 income do not satisfy either test. The answer permitting admission because Rule 205-3 does not bind an exempt reporting adviser ignores that the NASAA model rule imposes the qualified-client limit on this fund. The answer citing qualified purchasers misstates the standard, which applies to Section 3(c)(7) funds, not 3(c)(1) funds.
- Which of the following statements regarding a non-traded REIT is true?
Answer: A non-traded REIT's shares are not exchange-listed; investors cannot sell them at will, and redemption programs are limited and may be suspended during the offering.
Non-traded REIT marketability: A public non-traded REIT is registered with the SEC and files periodic reports, but its shares are not listed on an exchange, and investors generally cannot sell them at will. Sponsor repurchase programs are limited, often capped by a percentage of shares outstanding, and may be suspended while the primary offering is ongoing. The statement that a non-traded REIT typically guarantees its advertised distribution rate is wrong: distribution rates are estimates, not guarantees, and may be reduced. The statement that a public non-traded REIT is sold only through private placements to accredited investors is wrong: public non-traded REITs are registered offerings that may be sold to non-accredited investors subject to suitability standards, while private-placement REITs are a separate category. The statement that SEC rules require quarterly repurchases at net asset value is wrong: no such repurchase requirement exists, and any redemption program is established by the sponsor's terms.
- In tax year 2026, which of the following statements is correct regarding the federal income tax treatment of a publicly traded equity REIT and a private equity fund organized as a limited partnership?
Answer: The REIT pays no entity-level tax on income it distributes, while the private equity fund, a pass-through partnership, pays no entity-level tax and its investors are taxed annually on allocable income.
Under the Internal Revenue Code, a REIT may deduct dividends paid, so it is not taxed on the income it distributes, while a private equity fund organized as a limited partnership is a pass-through entity under Subchapter K that pays no entity-level tax, and its partners are taxed annually on their allocable share of income whether or not distributed. The statement that the REIT pays entity-level tax on all of its income and that shareholders exclude the distributions is wrong: the REIT is taxed only on undistributed income, and shareholders are taxed on distributions. The statement that both vehicles pay entity-level tax and that REIT shareholders receive a dividends-received deduction is wrong: the dividends-received deduction belongs to corporations receiving dividends from other corporations, not to REIT shareholders. The statement that REIT shareholders are taxed annually on their share of income while private equity fund investors are taxed only on distributions reverses both treatments: REIT shareholders are taxed on distributions they receive, and private fund partners are taxed on their allocable share annually.
A hedge fund charges a 20% incentive fee with a high-water mark defined as the highest year-end NAV per share before deducting the incentive fee. At the end of the most recent fiscal year, the fund's NAV per share was $100, which was also its high-water mark. Over the following three years, the fund's portfolio returns are +20% in year 1, -25% in year 2, and +20% in year 3, with no contributions or withdrawals.
Which of the following statements regarding incentive fees is correct? Answer: An incentive fee is earned in year 1 only; no fee is earned in year 3 because the NAV has not recovered to the high-water mark.
With the high-water mark at $100 at the start of year 1, the +20% return produces a pre-fee NAV of $120, so a 20% incentive fee is earned on the $20 gain and the high-water mark becomes $120. After the year-1 fee, the NAV is $116; the year-2 loss of 25% reduces it to $87; the year-3 gain of 20% brings it to $104.40, still below the $120 high-water mark, so no fee is earned in year 3. The statement that a fee is earned in year 3 because the cumulative return is positive applies the wrong test: the high-water mark, not cumulative performance, governs. The statement that a fee is earned in year 3 but not year 1 reverses the result, and the statement that a fee is earned in every positive-return year misstates the high-water mark rule.
