Whenever a real estate investor earns income from property distributions or from a profitable sale, that money is likely to be subject to either regular income tax or capital gains tax. But, one of the most significant benefits of a commercial real estate investment is that there are ways to reduce the tax liability on these sources of income. One of them is through an investment structure known as a Real Estate Investment Trust, or REIT for short.
In this article, we are going to describe two different ways that investors can interact with REITs, through creation of an UpREIT and a DownREIT. We will describe how these structures work, how they provide tax benefits, and the key differences between the two. By the end, readers will have the information needed to determine if one of these structures is a suitable fit for their own needs.
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Tax Scenario Setup
In order to understand what UpREITs and DownREITs are, it is first helpful to set up a scenario under which these structures may be pursued (NOTE: The scenario below is for illustrative purposes only and has been simplified to provide an example).
Suppose that an investor purchased retail property for $5MM and their plan was to hold it for ten years. Over the course of the ten years, the owner had great success raising rents, which caused the property to produce more income. In addition, the market was strong throughout the holding period, which resulted in a much higher market price at the time of sale – we will assume a sales price of $7.5MM. For simplicity’s sake, the difference between the cost and the sales price, $2.5MM, is classified as a “capital gain” and is a taxable event.
This is where the tax benefits of a commercial real estate investment kick in. There are a number of programs that investors can use to defer the capital gains tax bill and two of them are discussed in the next section.
UpREITs and DownREITs
UpREITs and DownREITs are two commercial real estate investment structures that provide a creative way for investors to defer their capital gains tax bill.
What is an UpREIT?
UpREIT is an acronym that stands for “Umbrella Partnership Real Estate Investment Trust” and it is a structure through which investors can defer capital gains taxes.
In an UpREIT, an investor who seeks to defer a gain contributes their property to a REIT in exchange for a share of the ownership interest in the REIT. This type of transaction is also known as a 721 Exchange. The logistics of the transaction can be tricky, but it usually works like this:
- Instead of selling their property outright, investors contribute the title of their property to a subsidiary of a REIT (an Operating Partnership).
- In return for their property, investors receive Operating Partnership Units in the REIT (“REIT Op Units”).
- In most cases, the REIT Op Units can be converted into REIT shares on a one to one basis (1 unit for 1 share). Ownership of these shares entitles the investor to their proportionate share of the income and profits produced by the underlying portfolio of REIT properties.
There are two major advantages to pursuing this type of transaction. The first is that by contributing the property to the REIT instead of selling it outright, investors can defer their tax bill until they sell their shares in the REIT. The second major benefit is diversification. Investors contribute one property to the REIT, but get back shares in a diversified portfolio of properties – which can reduce an investor’s overall risk level.
It is also worth mentioning that UpREIT property owners can be either an individual or a partnership, which means that they can also be a good way for families or partnerships to sell jointly owned properties and not incur a large tax bill.
What is a DownREIT?
A DownREIT is a joint venture between a property owner and a REIT that is created for the purpose of acquiring and controlling a commercial property. Again, the logistics of this transaction can be tricky, but it generally works like this:
- DownREIT investors work with a REIT to form a joint venture (as opposed to an operating partnership in an UpREIT)
- The property is contributed to the joint venture – usually a partnership
- In return, the property owners receive operating units in the joint venture, which entitles them to their proportionate share of the income and profits produced by the property.
Even with the structural differences, the net result of a successful transaction is the same as an UpREIT – tax deferral on an appreciated property.
Comparing UpREITs and DownREITs and Choosing The Right Option
Even if they have the same tax deferral outcome, there are key differences between UpREITs and DownREIT partnerships. Among the most notable:
- The Result: At the completion of an UpREIT transaction, real estate owners have shares in a diversified portfolio of real estate assets. At the completion of a DownREIT transaction, there may only be one property, so there is less diversification.
- Tax Benefits: For tax deferral purposes, investors tend to prefer UpREITs for their simplicity. The DownREIT structure is more complex and can be trickier to set up and operate. In addition, DownREITs may receive more attention or scrutiny from the IRS.
- Returns: Property returns can be tough to project, but if investors anticipate that the investment performance of their single property in the DownREIT is going to exceed the appreciation or produce more cash flow than the REIT’s portfolio of properties, it may make more sense to utilize the DownREIT structure.
Of course, it is up to each individual investor to research the specifics of the UpREITs and DownREITs and to work with their financial advisor or tax attorney to determine which option is the most suitable for their own individual needs.
How Do You Qualify for a 1031 Exchange?
Of course both the UpREIT structure and the DownREIT structure are alternatives to a more traditional tax deferral program known as a 1031 Exchange. In it, an investor can defer capital gains taxes as long as they reinvest the proceeds from the profitable sale of a property into another property that is “like kind” to the one that was sold. To qualify for this type of transaction, there are a number of rules that investors must follow. The detailed rules are outlined in section 1031 of the Internal Revenue Code, but the most important include:
- Investors must sell the property, as opposed to contributing the property to a limited partnership like they would in an UpREIT or DownREIT.
- From the date of sale, investors have 45 days to identify a suitable, like kind replacement property and 180 days to complete the purchase of it. The market value and debt in the replacement property must be the same as, or higher than the value and debt of the sold property.
- Both the sold property and the replacement property must be titled the same way
There are a number of other rules that are codified into tax law so investors should review them carefully or work with a Qualified Intermediary or tax attorney to ensure the transaction runs smoothly. If any of the rules are violated, it may become a taxable transaction.
Investing With a Private Equity Real Estate Firm
Finding and managing a suitable commercial property is an expensive and time consuming effort that requires a significant amount of expertise, capital, and industry knowledge. It is a lot for an individual to take on. For this reason, many individual investors prefer to partner with a private equity firm, like us, that does all of the hard work of finding, financing, and managing a commercial investment property on their behalf.
In a typical structure, the private equity firm – sometimes called the general partner – does all of the hard work of finding, financing, and managing a commercial property. In return, investors/shareholders get a fractional share of ownership in that property – which entitles them to their proportionate allocation of cash flow and profits that it produces.
Summary of UpREITS and DownREITs
UpREITs and DownREITs are two types of investment structures that can potentially allow investors to defer capital gains taxes on the sale of a property.
UpREIT is an acronym for “Umbrella Partnership Real Estate Investment Trust.” To defer capital gains taxes, investors can contribute their property to an operating subsidiary of a REIT. In return, they receive operating units in the REIT, which entitles them to their proportionate share of profits produced.
A DownREIT is similar in concept, but different structurally. In it, an investor forms a joint venture with a REIT and puts their property in it. In return, they also receive shares in the joint venture.
In both cases, the point is that the transaction allows investors to defer capital gains taxes, which can be a tremendous tax benefit over the long term.
There are nuances to the structures to each of these transactions so investors should review them to determine which is a better fit for their own financial circumstances.
Interested In Learning More?
First National Realty Partners is one of the leading private equity commercial real estate investment firms in the United States. We leverage decades of expertise to find world-class, multi-tenanted assets available below intrinsic value. We seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you would like to learn more about our investment opportunities, contact FNRP at (800) 605-4966 or firstname.lastname@example.org.