An umbrella partnership real estate investment trust (UPREIT) transaction may be a valuable alternative to a Section 1031 tax deferred like-kind exchange of real estate. UPREIT refers to an entity structure that has been used by real estate investment trusts (REITs) since 1992 to allow selling property owners the ability to convert their ownership of one or more of their specific real estate properties into an interest. The interest is immediately‚ or can ultimately be converted into‚ a private or public security.
In an UPREIT transaction‚ a property owner contributes its property to the operating partnership (OP) of a REIT in exchange for units in the OP (OP units). The same tax deferral is achieved as in a 1031 exchange‚ but with additional benefits.
An UPREIT transaction makes sense if a property owner is looking to achieve one or more of the following: (a) defer capital gains tax when appreciated real estate is sold; (b) eliminate management hassles of owning real estate; (c) diversify through ownership of a portfolio of properties; (d) upgrade to institutional quality real estate; (e) receive consistent quarterly income.
In an UPREIT transaction‚ property owners transfer their properties or partnership interests in their properties to the OP in exchange for OP units. The transfer is generally nontaxable if structured properly. The contributing partners can generally continue to defer some or all of the built-in gain in their contributed property until they exchange their partnership interests in the OP for shares in the REIT, or the contributed property is sold by the OP in a taxable exchange.
UPREIT transactions provide an attractive tax deferred exit strategy for owners of real estate who will recognize a significant taxable gain in a cash sale of a highly appreciated property with a low tax basis. The capital gains taxes remain deferred on the built-in gain as long as the OP holds the property and the OP Unit Holder holds the OP units. However‚ the OP can sell the property as part of a section 1031 exchange and avoid the recognition of gain to the OP Unit Holders that contributed the property. In this case, the remaining built-in gain transfers over to the replacement property acquired in the 1031 exchange.
While tax deferral/avoidance may be the primary incentive to entering into an UPREIT transaction‚ there are other substantial benefits for property owners completing an UPREIT transaction which are discussed below.
- Diversification of real estate holdings - The property owner converts an interest in one or more specific properties into an interest in a larger and more diversified portfolio of properties. Owning multiple properties, in multiple real estate markets, diversifies the property contributor's investment holdings and, as a result, mitigate the impact of a decline in the value or performance of any particular property.
- Depreciation deductions - In the case of a newly acquired or developed real estate property funded from the REIT’s capital raising, OP Unitholders will receive a share of the depreciation deductions from the depreciable asset in accordance with their respective interests in the OP. These depreciation deductions will reduce the taxable income allocated to the OP Unitholders by the OP with respect to their OP units.
- OP liability allocations – These allocations may allow property contributors to contribute property encumbered with a liability without recognizing any gain as long as the partner has allocated enough liabilities from the OP to cover its negative tax capital in the OP.
- Ability to convert real estate into more saleable securities (i.e., OP units → REIT shares → cash) – This offers the ability to convert an illiquid asset, like real estate, into an equity interest that may afford the owner a greater deal of optionality, flexibility, and liquidity. Subject to certain restrictions, OP units can be converted on a one-for-one basis into shares of common stock of the REIT. While such a conversion may trigger recognition of a taxable gain, the flexibility allows the owner to unlock value and access capital as needed. For example, the OP Unitholder can convert a portion of OP units into REIT shares over time instead of doing so all at once through the sale of a property. This, in turn, may help spread out and lessen the tax impact in any one year.
- Quarterly cash distributions from rental income - OP Unitholders receive the same quarterly distribution payments as stockholders receive from their REIT shares. If desired, these distributions can be reinvested into REIT shares which have the same value per share as OP units.
- Potential to recognize unrealized built-in-gains as earnings - REIT shares and OP units have the potential to increase in value and pay out higher distributions, and the OP Unitholder has the potential to recognize unrealized gains as dividends and share price increases, whereas unrealized gains are more difficult to tap into by typical property owners.
- Professional management and expertise in capital markets - Often, the REIT’s management will have asset management and/or capital markets expertise, which may improve debt financing and pricing.
- Simplified estate planning - Estate planning may also become simpler as heirs no longer need to take over management of a property or facilitate its sale. Heirs inherit OP units at a stepped-up tax basis upon the OP Unitholder’s death, and the Units can be divided among several people in the desired proportions.
- Allows the owner to dispose of its property in a way that maximizes its value – The property contributor can utilize the full equity value of their property to purchase an interest in an expanded portfolio of real estate assets while deferring gain recognition.
- Transaction structuring optionality - Exiting property owners may elect to receive UPREIT transaction proceeds in the form of OP units, cash, or a mix of the two. This offers optionality to investors who have a shared interest in a property, as some may wish to continue to participate in ownership of the assets for the long term as OP Unitholders, while others desire liquidity and would prefer to exit with cash.
In summary, an UPREIT transaction makes sense if a property owner is looking to defer capital gains tax on the sale of appreciated real estate while continuing to receive consistent quarterly cash flow. Property owners contemplating the use of an UPREIT transaction generally plan on a long-term hold (e.g., five to seven years) of the OP units in order to make full use of the tax deferral.
If a REIT structure seems like the right fit for you and your partners, please contact Citrin Cooperman’s Real Estate Practice or reach out to Stephen Lee at firstname.lastname@example.org for more information.
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