UPREITs and DownREITs Gain Popularity

These Partnership Transactions Are Replacing Section 1031 Like-Kind Exchanges.

In the early 1990s when the country was in the depths of a significant real estate downturn, many owners of real estate needed to infuse equity into troubled, overleveraged real estate portfolios. At the same time, Wall Street was looking to real estate investment trusts (REITs) as a new investment venue. In order to fill the equity void, REITs had to be reinvented.

Traditional methods of REIT formation normally had involved the transfer of real estate to a REIT in exchange for REIT stock. Unfortunately, this type of transaction generally is taxable if the property owner’s interests are diversified. Consequently, the umbrella partnership REIT (UPREIT) was conceived to overcome these tax difficulties. In the past five years, the UPREIT concept has evolved into many variations, including downREITs and umbrella partnerships in non-REIT situations.

Real estate operators, deal makers, and brokers need to understand these structures to be competitive. These transactions have many advantages over Section 1031 like-kind exchanges, which historically have been the transaction of choice for owners who seek to defer gain on the disposition of real estate.

The UPREIT Concept
When the UPREIT structure is used, the owner contributes property—usually subject to debt—to the umbrella partnership in exchange for limited-partnership units and a "put" option (see UPREIT chart). This usually is a nontaxable transfer. The owners of limited-partnership units can exercise their put option and convert their units into REIT shares or cash at the REIT’s option. This normally is a taxable event for the holder of units. Therefore, most unit holders do not exercise their puts. Upon the death of a unit holder, the tax basis of his units is stepped up to market value. Therefore, the heirs can exercise the put without incurring income tax on the appreciation of the underlying assets. The principal advantage of exercising the put at death is to provide liquidity to the estate and to prevent income taxation of subsequent appreciation.

All properties and management functions usually are downstreamed to the umbrella partnership. In other words, the REIT is essentially a holding company. Its principal asset is its interest in the umbrella partnership. The advantage of this structure is that the limited-partnership units will mirror the performance of the REIT shares. This removes many perceived conflicts between the holders of partnership units and REIT shareholders. It also simplifies the conversion that will occur when the puts are exercised. Normally one partnership unit can be converted into one REIT share or an equivalent amount of cash.

REITs can use the tax deferral advantages of the UPREIT structure to facilitate the acquisition of additional properties. Instead of paying cash, UPREITs can issue limited-partnership units in exchange for the property, deferring the taxable gain that the property owner would have recognized upon sale. In 1993, UPREITs began using limited-partnership units as currency and found themselves in a more advantageous position than other potential buyers of property.

The DownREIT Alternative
In response to UPREITs, many conventionally structured REITs either have had to convert to an UPREIT structure or use a newer type of structure called the downREIT. (Although UPREIT is an acronym for umbrella partnership REIT, the term downREIT is not an acronym. Its name probably was derived to distinguish its structure from that of an UPREIT.)

Unlike an UPREIT, where all activities are performed at the operating partnership level, the downREIT is a joint venture between the REIT and the property owner (see downREIT chart). Only the property owner’s assets are held at the partnership level. Therefore, the partnership’s performance does not mirror the performance of the REIT. Consequently, either the mechanics of the put option become complex or the fundamental economics of the non-REIT partnership interests are altered so that they are not based solely on the performance of the assets held by the partnership. Typically, the conversion is based on the value of the joint venture’s assets at the time of conversion. A downREIT transaction probably is most appropriate when the property owner believes that his property will outperform the rest of the REIT’s portfolio.

If the conversion is based on something other than the economics of the joint venture, there is a risk that the Internal Revenue Service (IRS) will not recognize the integrity of the partnership’s existence or the integrity of the partnership’s allocations. The IRS has issued anti-abuse regulations dealing with circumstances when the integrity of a partnership will be respected. If the existence of the partnership is not respected, the IRS probably will take the position that the partnership units are merely a second class of REIT stock—and that the transfer of property to the REIT in exchange for stock is taxable to the property owner. The UPREIT structure is specifically addressed in examples contained in the anti-abuse regulations. However, no such examples address downREIT transactions. Thus, there is greater uncertainty regarding the tax position of the downREIT under certain circumstances.

Deferral of Taxable Gain
As noted, the property owner’s tax is deferred when the assets are transferred to the UPREIT or downREIT partnership. This deferral generally lasts until the partnership sells the property in a taxable transaction or when the property owner converts his partnership units to REIT shares or cash. Since the property owner generally can control the timing of a conversion, usually there are no restrictions on the exercise of the put option. But, in order to meet certain securities law requirements, the put often cannot be exercised for the first year after the option is granted.

However, the property owner usually negotiates some sort of standstill agreement wherein the REIT agrees not to sell the property in a taxable disposition for some period of time, usually between five and 10 years. At the expiration of the standstill period, the REIT usually agrees to some sort of lesser remediation such as a best-effort attempt to facilitate a Section 1031 exchange in lieu of a sale, or the property owner will be given a right of first refusal (or possibly a right of first offer) to repurchase the property in a manner that will continue to defer the owner’s tax.

Debt Paydown
As previously mentioned, the property that is contributed to an UPREIT or downREIT partnership frequently is encumbered by debt. More often than not, the amount of such debt exceeds the property owner’s income tax basis in the property. When this happens, the contributor has a deficit balance in the tax basis capital account of his interest in the partnership. The amount of such a deficit usually is the amount by which the mortgage exceeds the tax basis of the encumbered property. A partner’s basis in the partnership interest generally is determined by combining the historical cost tax basis capital account with the partner’s distributive share of partnership liabilities. Since a partner’s basis in the partnership interest never can be less than zero (in order to avoid the recognition of gain) a partner with a deficit balance in his capital account must, at all times, have sufficient debt allocated to him to offset the deficit. If the debt is reduced below this level, the property owner will have a taxable gain equal to the shortfall.

Unless the terms of the existing debt are extremely favorable, the REIT usually is motivated to reduce the amount of its leverage and will want to pay down the mortgage debt over a relatively short term. When this debt is paid down, the partners with a deficit capital account may recognize a taxable gain. To avoid this, the partners frequently guarantee some portion of the debt. It is also common for the REIT to agree to a standstill period during which it agrees to leave the debt in place.

Another solution is to restructure the asset ownership simultaneously with the partnership transfer. This typically is accomplished through a bifurcation of the debt into two separate loans, one collateralized by the improvements, while the other is encumbered by the fee interest in the land. A ground lease—typically 50 to 75 years—between the partnership and the property owner is executed simultaneously with the transfer of the improvements to the partnership.

The idea behind the transfer is to minimize the debt associated with the improvements. (If this approach is used, a competent tax advisor should be consulted to ensure that no disguised sale issues exist. In short, if the relative debt is disproportionate to the respective values of the underlying collateral, the IRS might attempt to recharacterize the transactions as a partial sale.) The result is a smaller partnership capital account deficit that must be protected by partnership-level debt.

Accounting for Built-in Gains
When the property owner contributes assets to a partnership, the partnership steps into the shoes of the property owner. In other words, the basis of the property in the hands of the partnership is the same as that of the contributor. However, the fair market value of such assets normally differs from the tax basis. The tax laws—Section 704(c) of the Internal Revenue Code (IRC)—require that income attributable to appreciated assets (or unrealized loss attributable to depreciated assets) that are contributed to a partnership be allocated in a manner such that the contributing partner is charged with, or benefits from, respectively, the unrealized gain or loss associated with the property at the time of the contribution. The amount of such precontribution gain or loss generally is equal to the difference between the fair market value of contributed property at the time of contribution and the adjusted tax basis of the property at such time—a "book-tax difference."

In the event of appreciated assets, generally the contributing property owner will be allocated depreciation deductions for tax purposes that are lower than such deductions would be if determined on a pro-rata basis. Therefore, the book-tax difference is reduced—or cured—over time as the asset is depreciated. Further, in the event of the disposition of any of the contributed assets that have an uncured book-tax difference, all income attributable to such book-tax difference generally will be allocated to the contributing property owner, and the other partners generally will be allocated only their share of gains attributable to appreciation occurring after the assets were contributed to the partnership. This should eliminate the book-tax difference over the life of the partnership. The Treasury Department regulations provide partnerships with a choice of several methods of accounting for book-tax differences. The method usually used is negotiated by the parties.

Non-REIT Applications
Although REITs are the major impetus behind partnership transactions, many institutional investors and other private sources of capital also are using these structures. To provide liquidity, the put option usually involves a cash sale as the exit strategy for the property owner.

Many property owners are concerned that REIT stocks are overpriced, and therefore, are not interested in converting to REIT shares based on today’s values. This can be overcome by using a downREIT structure with the conversion price based on the performance of the assets of the downREIT partnership. However, if those owners want diversification, frequently their best alternative may be an umbrella partnership structure with a private capital source.

Section 1031 Exchange Comparison
Traditionally, investors seeking to defer gains on appreciated real estate have undertaken like-kind exchanges, in which the IRC allows an owner of real property used in a trade or business to exchange the property for other real estate of a like kind if certain conditions are met.

However, these transactions have limitations. For example, replacement property must be identified within 45 days and the acquisition of the replacement property must be consummated within 180 days. Moreover, such exchanges do not provide for diversification, future liquidity, the ability to dispose of a partial interest, or an exit strategy. For these reasons, the various partnership exchange transactions have become a viable alternative to traditional Section 1031 like-kind exchanges.

Any UPREIT or downREIT transaction is complex; partnership units are securities, and their issuance can have serious securities laws implications. Therefore, competent tax and securities counsel should be consulted. With that important caveat in mind, partnership transactions have significant advantages over the more traditional like-kind exchange. The brokers and other real estate professionals who understand their structure will remain competitive.

James P. deBree, Jr.

James P. deBree, Jr., is a tax partner with the REIT Advisory Group of Deloitte & Touche, LLP, in Los Angeles. You can reach him at (203) 688-5261.