The Reit Way Versus the Wrong Way

A REIT is a REIT, right? Wrong. UPREITs, DownREITS and OP units litter the REIT landscape making it more critical than ever to know which is right – and which is wrong – for any real estate transaction. Let Real Estate Forum editor John Salustri lay it all out for you.

Ah, for the simple days of yesteryear, when you simply received cold, hard cash for your real estate sale and took the monster tax hit with the grit of a pioneer. But, like other marks of true grit – such as outdoor plumbing and cooking without a microwave – less painful methods have emerged. There’s a brave new world of real estate investments out there, the likes of which were unimagined a generation ago.

From UPREITs to DownREITs:

Today, the market has evolved into a sophisticated network of options designed to maximize the upside of real estate acquisitions and dispositions and minimize the downside of IRS burdens. But with this sophistication comes a great deal of confusion, and talk of real estate investment trusts (REITs), and their variations – UPREITs and DownREITs – which can send the first-time investor reeling. Add to this the option of operating partnership (OP) units, and one can certainly begin to miss the good old days.

But, while OP units may not be as simple as a straight cash investment, they are designed to aid the investor by providing shelter from heavy tax burdens and a means for investment growth. «It’s really a different form of currency, explains Larry Feldman. «People need to get comfortable with how the tax shelter works.

Some History:

To advance the first-time investor’s comfort level, a little history is in order. As a means of addressing the tax hit that resulted from a real estate purchase, investors have long taken advantage of a section in the tax code called a 1031 Exchange. «This, basically, allowed a person to defer a capital gain by trading one real estate asset for another, explains David Seaman, a director at Coopers & Lybrand LLP in New York City. He notes that the exchange had to be for an asset of equal or higher value.

While the exchange offered a respectable means of sheltering gains, it was ultimately just a postponement and offered no means to liquidate the assets.

Then, along came real estate investment trusts. Although REITs have only begun to dominate the real estate scene during the past few years, they have actually been around, in one form or another, for more than 25 years. But in the current up-cycle, their benefits to investors have come to full flower. Through the REIT structure says, Mr. Seaman, investors could now exchange their asset purchases for an interest with equivalent value in a REIT. But, while the contributor was free from the tax burden of a gain at the time of transfer, he would still be liable for the difference, if any, between the basis of the property and the fair market value at the time of transfer.

So refinement was still in order, and thus was born the UPREIT. «The Umbrella Partnership REIT – the UPREIT – allows the investor to actually become a REIT and take advantage of this valuation while still deferring gains from the transfer of assets, explains Mr. Seaman.

«In an UPREIT, says the Coopers director, «the owner transfers property to an umbrella partnership, called an Operating Partnership (OP for short), and the newly formed REIT functions merely as the managing partner of the OP. The owner then receives ‘OP units’ in exchange for the real estate.

Capital gains taxes are deferred until the units are converted to common stock. In addition to this tax deferral, the company can use the OP units as currency to expand its existing portfolio. And in this way, the seller in turn is granted a tax deferral on his capital gains.

As for DownREITs, they are similar to UPREITs, mimicking their structure, but possess one key difference: no single partnership owns all the properties. The contributor becomes a limited partner.

Bottom Line:

So how does this translate into the tax-sheltered sale of a building? Let’s assume you are selling a $100-million property with a $30-million depreciated basis. You have $70 million in capital gains exposure at a 28% rate. But instead of getting cash, which is an immediate taxable event, the seller takes back OP units and defers the capital gains until he decides to convert his OP units to stock. Essentially, the investor is converting one form of ownership to another.

Of course, it’s not quite that simple or that cut-and-dried. There is always an element of risk, and the investor has to be comfortable before venturing into this type of transfer.

«It’s a form of currency that’s very different from cash, and investors must be comfortable with that concept, Larry Feldman warns. «They must be comfortable that their REIT will continue to grow and that their OP units will continue to appreciate and throw off dividends. They must also be confident that the stock market will continue to hold up.

But for now at least, the real estate market – and the economy that is supporting it – is strong indeed, and despite minor hiccups, the stock market is pumping on all cylinders. This bodes well for REITs in general and UPREITS in particular.

«As people become more fluent in the workings of OP units and how they can shelter tax gains, OP units will continue to be an attractive means of doing business, Larry Feldman concludes.