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UPREIT vs. DownREIT – Why UPREITs Are Great for Taxes

UPREIT vs. DownREIT – Why UPREITs Are Great for Taxes

What is an UPREIT?

A specific kind of real estate investment trust is a UPREIT. A taxable or tax-free partnership can be turned into a REIT using the UPREIT structure. A property owner who would prefer REIT stock to cash can also use the UPREIT as a tax-deferred mechanism. If you have a partnership interest, you might want to think about converting it through a UPREIT transaction.

What Is DownREIT?

DownREIT is a joint endeavor between a real estate owner and a real estate investment trust (REIT) for the purpose of acquiring and controlling real estate.

KEY TAKEAWAYS

  • A DownREIT is a partnership agreement that allows for the deferral of tax on the sale of appreciated real estate and is made up of a REIT and a property owner.
  • DownREITs come in two varieties. While REITs make little to no capital contributions in the first type, they make a sizeable capital contribution in the second.
  • In comparison to UPREITs, DownREITs are more complex, and they may have tax repercussions if the IRS views the operating unit as a security.

Understanding DownREIT

To help a real estate owner delay paying capital gains tax on the sale of appreciated real estate, DownREIT involves a partnership agreement between the real estate investment trust (REIT) and the real estate owner. To make it easier for investors to put money into the real estate market, the UPREIT was created after the real estate slump of the 1990s. From the UPREIT, DownREIT emerged.

Property owners who donate their assets to DownREITs receive operating units in a partnership. Depending on the REIT and any UPREITs that may exist, this partnership entity and the relationship of the property owner to it may be drafted in a variety of ways. To sell contributed assets in a DownREIT, the REIT must consent to a lockout or standstill agreement. 2

DownREIT partnership categories come in two different varieties. In the first kind of partnership, the REIT contributes little to nothing in terms of capital, and limited partners are given preference when it comes to receiving operating cash distributions in an amount corresponding to REIT share dividends. The second type of REIT requires a sizable capital contribution from the REIT. The return of capital is distributed to the general partner.

DownREIT Compared to UPREIT

Because it is more complicated and might not offer the same tax benefits as an UPREIT, the DownREIT is less popular than the UPREIT. Contributing real estate to a DownREIT is a complicated transaction that calls for expert tax and financial advice. The transfer of property into the DownREIT in exchange for operating units may be regarded by the IRS as a taxable transaction under the disguised-sale or anti-abuse rules if the transaction is not carefully structured. As a result, an UPREIT may be the more sensible option for a property owner whose main priority is to postpone paying income taxes.

A DownREIT involves real estate ownership, in contrast to UPREITs where this is not the case. Some of this real estate is owned outright, while other portions may be held in limited partnerships with individuals who have contributed assets.

Because he retains a greater interest in his contributed property with a DownREIT than he would with a UPREIT, a DownREIT can be a sensible choice if the property owner believes his real estate will appreciate more than the REIT’s other holdings.

However, because a DownREIT’s ownership structure is more intricate, more complicated math is needed to convert operating units to cash. The different ways that UPREITs and DownREITs are structured also affect how well they perform as investments. A DownREIT enables the partnership between the REIT and the investor to perform differently from the REIT’s overall performance.

But when it comes to their usefulness as an estate planning tool, DownREITs and UPREITs are comparable. Both raise the operating units’ basis upon the owner’s passing, enabling the transfer of appreciated real estate to heirs tax-free. After that, the operating units can be converted tax-free into REIT shares or cash by the heirs.

An UPREIT is much better than DownREIT

An UPREIT is a special type of REIT. It’s designed to convert taxable or tax-free partnerships into REITs in order to avoid the tax consequences of converting a partnership into a REIT.

UPREITs are typically used by real estate investment groups with large portfolios of properties and/or other assets who want to take advantage of their real estate investments without having to pay taxes on them.

The UPREIT structure can be used to convert either a taxable or a tax-free partnership into a REIT.

An upreit is a structure that allows partners to convert their taxable or tax-free partnership into a REIT. This means that the partnership can avoid being taxed at the individual level, thus becoming more like an operating company (or “OPC”).

Upreit structures can be used for either taxable partnerships or tax-free partnerships. When a taxable partnership becomes an UPREIT, it is taxed at the entity level as if it were an OPC and is therefore not subject to individual taxation upon distribution to its partners. A UPREIT will also receive limited liability protection because it does not pay out funds directly to its investors; instead, those investors must sell their shares in order to receive distributions from their investment in the REIT fund.[2]

Ge out of A DownREIT and into an UPREIT

The UPREIT is also used as a tax-deferred mechanism for an owner of property who would prefer REIT stock to cash. In this case, the owner will sell their property to the REIT, who then pays the seller cash for it. The result is that the original owner has now sold their property and received cash in exchange for it.

If you own DownREITs, convert to UPREITs.

If you own an interest in a partnership, you may want to consider converting that partnership through an UPREIT transaction.

UPREIT Units do not pay tax at the entity level. They are flow through securities that are taxed at the shareholder level. Earnings from operations or sale proceeds will also be paid out of the trust without liability for corporate tax.

Transferring partnership to the REIT in exchange for Units

To do this, the partner will transfer its partnership interest to the REIT in exchange for Units of beneficial interest (“UPREIT Units”) representing an ownership interest in the operating partnership of the REIT. The UPREIT Units will be issued by a newly formed corporate subsidiary of the REIT and will be issued on a pro rata basis to each partner based on their respective interests in each property contributed to the purchase group. In addition, under certain circumstances, if at least one property contributed is already subject to significant debt financing or has been developed or improved with some equity capital provided by a non-contributing owner, then no UPREIT Unit would be issued until such debt has been repaid or defeased (or refinanced) or such equity contribution has been returned at least equal to its cost plus interest thereon at prevailing rates over five years from date of contribution (with such return being made out of pre-tax earnings).

You Pay no tax on UPREIT Units

When it comes to taxes and UPREIT vs. DownREIT, UPREIT wins hands down. Typically, the partners can pay no tax on the receipt of UPREIT Units by including the fair market value of the contributed property in the basis of the Units received for federal income tax purposes (the “Step Up”). In this case, no taxable gain or loss is recognized when a partner sells his/her UPREIT Units. In addition, if distributions from operations or sale proceeds include items that are not subject to tax under section 301(a), those items will be taxed at ordinary income rates and not at capital gains rates.

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These steps avoid taxation at both the entity and shareholder levels with regard to distributions from operations or sale proceeds.

  • Avoidance of double taxation.
  • A partnership is not subject to tax at the entity level, but generally its income passes through to the partners and is taxed on their personal returns. By contrast, in a REIT, most of the entity’s profits are paid out as dividends, which are then taxable income for shareholders. When a REIT sells assets or repurchases shares, there is no double taxation since all sales proceeds are distributed to shareholders who then pay taxes on those amounts. (This does not apply if you’ve made any nondeductible contributions and want to keep them.)
  • Instead of paying taxes twice (i.e., once at the partnership level and again at your individual rate when distributions are made), shareholders in a REIT avoid paying taxes twice by receiving distributions from operations or sale proceeds that have already been taxed at the corporate level and thus do not have an impact on their return after selling their interest in real estate investments.

Converting your partnership into an UPREIT can provide multiple benefits.

Converting your partnership into an UPREIT can provide multiple benefits. First and foremost, it avoids taxes on the entity level and at the shareholder level. If you want to attract outside investors, then consider converting your partnership into an upreit.

After conversion of your partnership into an UPREIT, you will no longer be required to pay taxes at both the entity and shareholder levels. This will save yourself money in terms of tax liabilities. Converting your partnership into an UPREIT also provides a step-up in basis for all assets held by that entity since its inception date as well as ongoing operations or sale proceeds from those assets based on fair market value (FMV).

Conclusion

UPREIT vs. DownREIT? Converting your partnership into an UPREIT can provide multiple benefits. The tax-deferred conversion of your partnership interest into UPREIT Units provides a mechanism for converting your partnership interests into REIT stock, which has the potential to increase in value over time. The Step Up avoids the immediate taxable event that would otherwise occur if you sold an interest in a partnership.

In addition, some partnerships may be able to take advantage of an exclusion from Section 751(b) by converting their interests into UPREIT Units and then selling those units back to the operating partnership in exchange for cash or other property (such as real estate). This type of transaction is referred to as a 751(b) exchange because it qualifies under Section 751(b)(1).


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