Could someone please explain what “pass through” means? I can’t find where its explained and its a recurring question in the quizzes. I don’t understand the terminology very well.
Hi @Specified_red_slug! Thanks for reaching out on our forum.
A “pass through” investment is one that has the ability to pass both gains and losses to its investors. Let’s explore an example of a pass through security, and one that isn’t.
Limited partnerships are some of the most commonly cited pass through securities. When an investor obtains an interest (gains ownership) in the partnership (as a limited partner), they are “directly participating” in the gains and losses of the business. Keep in mind any business can be setup as a limited partnership, although we most commonly cite oil & gas and real estate programs in the Series 7.
It’s a bit more complicated than this in the real world, but when a limited partnership business makes a profit or loss, it can pass through either to its investors. For example, assume you’re a limited partner in a wildcat oil & gas program. For the first year in business, the program does not find any oil, and therefore loses a significant amount of money on its operations. When it’s time to file taxes, the limited partnership “passes through” the losses to the its partners, who receive tax forms detailing this information. When they file their taxes, the losses demonstrated on the tax forms allow certain tax deductions, often times resulting in lower taxes. Only pass through securities allow the pass through of losses to their investors.
Pass through securities also allow for the pass through of gains. Going back to our example, let’s assume the wildcat oil & gas program makes a profit in its second year of operation. That profit is reported on tax forms (similar to how losses are reported) and sent to the partners. From there, the partners will pay taxes on their share of the gains.
An example of a non-pass through security is common stock. Assume you own stock in Coca-cola (KO). If Coca-cola has a bad business year, they will report their losses on their financial disclosures (the 10Q or 10K), but they may not “pass through” this loss to investors. The only way a common stock investor may claim a loss on common stock is to sell the security at a lower price than its cost basis. There’s no way to claim a loss while owning the investment, unlike pass through securities.
However, non-pass through securities like common stock can pass through gains to investors. Companies like Coca-cola pass through gains in the form of cash dividends, which are typically paid quarterly (if paid at all).
Hopefully this helps with understanding what a pass through investment is. Please let me know if you have any other questions.
This was extremely helpful! I have a much better understanding now, thank you for your detailed explanation!