By: Gail Schneck, Chief Executive Officer of FactRight, LLC
A growing number of non-traded real estate investment trusts are seeking to expand their funding sources by offering section 1031 exchange investment properties that may later be (re)acquired by the REIT through an umbrella partnership real estate investment trust (UPREIT) transaction. Such transactions allow investors to diversify their holdings into the operating partnership (OP) of a REIT that is likely to own multiple properties.
And if the ability to enter into section 1031 exchanges is substantially curtailed—as President Biden has recently proposed—the UPREIT option may still provide investors who have already entered into an affiliated Delaware statutory trust (DST) with the ability to continue to defer taxes (at least until the property acquired is sold or refinanced) under section 721 of the Internal Revenue Code, which provides for continued tax deferral of the original capital gains.
This is why we are also seeing a number of REITs emerge, after the issuance of DSTs by the same sponsor, to provide an UPREIT exit. A DST with an UPREIT structure may provide a significant opportunity to the right investors, but they must understand the ramifications of such investments. Let’s look at the main considerations for determining whether investing in a DST program with an UPREIT option is appropriate for your client.
What kind of investors should consider this kind of program?
Through an UPREIT option, investors would exchange their DST interests for units in a REIT’s OP at the time the REIT or an affiliate exercises its option to purchase the DST property. Assessing whether your client has the right to receive cash proceeds to potentially pursue a subsequent 1031 exchange, if available, in lieu of OP units is a critical inquiry.
Many REIT programs do not give the investors a cash-out option, or limit the amount of sales proceeds that may be paid in cash. In those cases, an investor interested in a future section 1031 exchange might not be suitable. However, even those programs that do give investors an option to take cash a subsequent 1031 exchange may not be viable in the future depending on the fate of section 1031.
Thus, the DST/UPREIT arrangement is most appropriate for investors seeking diversification and easier liquidity for their heirs, who are also comfortable with a relatively large eventual investment in a non-traded REIT.
What exactly would your client be UPREITing into?
My father once told me that it is unwise to make investment decisions based on tax consequences alone. And he was a tax lawyer. It is one thing to diversify a portfolio. It is another to assess what you are diversifying into. Before investing in a DST program with an UPREIT option, you and your client should step back and ask whether an eventual investment in the REIT is sound absent the potential tax advantages. After all, these programs can materially vary in the level of diversification offered, risk/return profile, quality of the portfolio, and fee structure.
What happens if the UPREIT transaction doesn’t occur?
The option is exercisable at the discretion of the REIT. Most programs intend to UPREIT the property and therefore expand the capital raise of the REIT by capturing the equity raised from the prior DST syndication. But the REIT is under no obligation to do so and may decide to pass on the repurchase if property performance deteriorates over the holding period. So investors may face taxes on capital gains when the DST exits, at potentially higher rates than prevail today, since 1031 may not be an option in the future. Of course, this prospect faces investors in any DST program these days.
Ultimately, your client must have the resources to be prepared for various outcomes in the future, in addition to being suitable for the REIT investment.
What type of liquidity does the REIT provide?
If the UPREIT transaction does occur, usually investors are required to hold the OP units for at least a year before they can be converted into REIT shares and liquidated. Upon conversion, the investors can take advantage of the repurchase program included in the REIT structure. Repurchase program features vary among and between public and private REITs. But liquidity is not guaranteed—one common feature is that these programs can be suspended or terminated without investor consent.
Safeguards for affiliated transactions
The UPREIT structure presents affiliated transaction-related risk, often at the beginning and certainly at the end of the DST investment.
On the front-end, some programs acquire properties for the DST from third parties, which they then intend to UPREIT. Other programs have the OP acquire the property, or they take an existing OP property, and drop them down into the DST. Affiliated transactions, such as the latter scenarios, require additional safeguards surrounding determination of the DST purchase price such as independent appraisals.
At the DST exit, the same third-party appraisal considerations apply. How close in time to the UPREIT transaction must that appraisal be obtained? Also, note whether the sponsor might earn a disposition fee on the roll-up transaction (whether or not the affiliated REIT will be paying them an acquisition fee). Some DST sponsors are not entitled to transaction fees for an affiliated exit, which may help to mitigate conflicts of interest, while others are.
Tax deferral forever?
One of the biggest advantages of the UPREIT structure is that investors can create diversification by exchanging DST interests into the OP of the REIT, and if properly done through a section 721 exchange, continue to defer capital gains taxes. But this tax deferral may not be forever. Subsequent conversion of OP units into common shares is a taxable event. In addition, if the REIT sells or refinances the property originally acquired through the UPREIT transaction down the road, investors may also be hit with a tax liability, which is why many REIT programs offer tax protection agreements. However, these tax protections are often limited in duration to between five and ten years.
One of the strengths of section 1031 (as it now stands) is the ability for the investors to “swap ‘til they drop,” the latter part of that phrase a euphemism for an event that affords a stepped up basis for heirs, effectively eliminating capital gain liability at that time. While UPREIT programs can offer diversification and liquidity, at some point the tax liability may loom, in part because investors will no longer have the ability to enter into another 1031 exchange. From a liquidity standpoint though, after as little as one year, investors may exit the REIT by converting OP shares into common shares. Of course, this liquidity is dependent upon the repurchase feature provided by the REIT.
Overall, the UPREIT strategy probably makes the most sense for investors who have no need of funds and want to pass a more liquid, diversified holding to heirs. If you’re looking for more information on UPREIT transactions or due diligence services in the alternative investment space, please contact Gail Schneck or any member of the FactRight team for further assistance.
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