Brokers & Sellers > Tax-deferred/UPREIT Transactions

Tax-deferred/UPREIT Transaction

Contributing property to the Operating Partnership of a REIT in exchange for limited partnership interests in the Operating Partnership will have positive consequences for the contributor/seller: tax will be deferred, liquidity will be increased, and the REIT will take over management of the contributed property.

As an owner of multifamily apartment property, you may be considering whether and how to sell. As a legal or tax advisor to a multifamily apartment property owner, you may be called upon to advise your client about whether to sell and ways to sell in a tax-deferred manner. This memorandum discusses one way to sell in a tax-deferred manner: contributing property to the Operating Partnership of a Real Estate Investment Trust ("REIT") in exchange for limited partnership interests in the Operating Partnership, known as an UPREIT deal.

Decision to Sell

The decision to sell is not an easy one. The fundamental nature of real property as an investment may be clouded by other considerations, including emotional considerations such as long-time family ownership of and involvement with the property. Some pros and cons of multifamily property ownership are:

1. Benefits to Owning Individual Multifamily Properties
   1. Control — Long-time owners may be very comfortable with their properties and may be very involved in day-to-day management.
   2. Firsthand knowledge/information — A hands-on owner may have intimate knowledge of residents, staff, and generally how the investment is doing. This control and knowledge can be very comforting.
   3. Status Quo (safe) — It may be hard to step back and view the property as an investment and consider whether its investment value is being maximized.
2. Negative aspects of Owning Individual Multifamily Properties
   1. Management issues — the owner may be tired of being involved in management but unable to find a management company that meets his needs.
   2. Deferred Maintenance/Capital Improvements — the property may need expensive repairs or upgrades that the partnership cannot afford or does not want to undertake.
   3. Differing viewpoints among partners - Partners may disagree about management of the property or not be satisfied with their returns.
   4. Next generation — What if the owner's children do not want the property or cannot agree about how to manage it?
   5. Market risk greater in a single market — Local economic factors will have a greater impact on properties in a single market.
   6. Lack of liquidity — Along the continuum of liquidity, ownership of one or more multifamily properties is very far away from cash or a fully liquid investment.

Sale for Cash — Taxable Event

Assuming the owner decides to sell, many owners would simply sell for cash. This would accomplish the owner's purpose in disposing of the property. The owner can reinvest the cash in stocks, bonds, mutual funds, or other investments. There would obviously be a significant improvement in liquidity. Unfortunately, in current market conditions, the return on the stocks may not be attractive, and the return on bonds or other funds may be minimal. In addition, in a normal taxable transaction, a huge amount of the sale proceeds will be applied to pay gains tax.

Tax-deferred Methods of Selling

With some planning and assistance from advisors, the owner can structure the sale in a way that defers tax on gain. One way to defer tax is to exchange the multifamily property for other real property in a 1031 exchange (Section 1031 of the Internal Revenue Code). Another way to defer tax is to contribute the property to a real estate investment trust ("REIT") in exchange for interests in an affiliate of the REIT (UPREIT transaction pursuant to Section 721 of the Internal Revenue Code).

Tax-deferred Method #1: 1031 Exchange
The first alternative to a cash sale is a 1031 exchange. Basically, Section 1031 of the Internal Revenue Code allows you to exchange your apartment property for other real property (it could be residential, commercial, or other real property). The sold property is referred to as "relinquished" property and the acquired property is referred to as "replacement" property. If done correctly, the IRS will deem this an "exchange" rather than a "sale" and gain on the sale will be deferred. The owner will not receive cash from this exchange, or, to the extent the owner receives cash, gains tax will be due.

Note that the replacement property must be real property. A limited partnership interest in a partnership that owns property is not acceptable replacement property. (If it worked, this would be a way to minimize risk and end management responsibilities.) If the owner seeks to continue to directly own real property, the 1031 exchange may be the perfect vehicle. It will allow the owner to start over with a different multifamily property, perhaps in a more lucrative market, or to acquire a commercial property. In addition, for owners who place significant value on control or hands-on management, the 1031 exchange will allow them to continue to manage an individual property.

However, depending on the circumstances, the 1031 exchange may not be the best strategy for the owner:

1. No change in liquidity. The owner has sold one multifamily property and has acquired a new property.
2. No change in management issues. The owner needs to remain involved in management or find a good manager.
3. The same taxpayer that sold the relinquished property must buy the replacement property. This means that the existing partnership must acquire the replacement property. This may or may not work. One or two or more partners may not cooperate. If they own a significant enough share of the partnership, or if the partnership requires 100% consent to a "sale," they may be able to stop the transaction, and the general partner may not have enough cash to buy them out.
4. The timing of the purchase and sale must fall within the 1031 Code parameters. This sounds easy but in practice it is very hard. Within 45 days after the sale, the owner must identify the replacement property it plans to buy, and within 180 days after the sale, the owner must acquire one of the identified properties. The only way to be absolutely sure the 1031 exchange is completed correctly would be to close the purchase and sale simultaneously, or within days of each other. In practice, negotiating both purchase and sale and having them close at the same time is very difficult. Using the right advisors is very important, as the transaction must be done within the IRS-mandated parameters, including timing and flow of funds (must be done through a 1031 exchange agent).

Tax-deferred Method #2: UPREIT Deal
The second tax-deferred alternative is an UPREIT deal. It has the same tax avoidance benefits as a 1031 exchange without the timing difficulties or continued management responsibilities. Unlike a 1031 exchange, it will improve liquidity. In an UPREIT deal, the owner contributes property (or partnership interests) to the Operating Partnership of a REIT in exchange for limited partnership interests in the Operating Partnership. Section 721 of the Internal Revenue Code treats this type of transaction as tax-deferred.

Background on REITs and OP Units

What is a REIT?
"REIT" means Real Estate Investment Trust. A REIT is a corporation which is entitled to special federal (and in many cases, state) tax treatment. Essentially, there is no tax at the corporate level. In exchange for this special treatment, the REIT must comply with several requirements. Probably the most important of these is that the REIT must distribute 90% of its income annually. (The tax exemption is accomplished by allowing a deduction for dividends paid to the extent income is distributed.) However, a corporation is not a great vehicle for owning real estate. If all of the original sponsors of the REIT had sold their properties to the REIT directly in exchange for shares of stock in the REIT, it would have been a sale and they would have had to pay capital gains tax.

What is an UPREIT?
"UPREIT" means Umbrella Partnership Real Estate Investment Trust. An UPREIT structure involves two entities: the Umbrella Partnership and the REIT. The REIT does not own any properties directly; rather, it owns a controlling interest in a limited partnership that, in turn, owns the real estate.

UPREIT = Operating Partnership
The Umbrella Partnership is more commonly referred to as an "Operating Partnership" or "OP." The Operating Partnership is the entity through which the REIT operates. In addition to allowing for additional flexibility in terms of operations, having the Operating Partnership allowed the original sponsors to contribute their properties to the Operating Partnership in exchange for partnership interests without triggering gain. In the same way as the original sponsors, an owner would contribute its property to the Operating Partnership in exchange for OP Units (limited partnership interests in the OP). The Operating Partnership is controlled by its general partner, the REIT. The Operating Partnership owns the properties, either directly or through one or more subsidiaries. The Operating Partnership is also the entity which receives all income from the properties. The limited partners of the Operating Partnership (called "OP Unit Holders") are individuals who contributed their properties in exchange for OP Units in the OP. Basically the only ticket into the Operating Partnership is by contributing property to the OP in exchange for OP Units.

What are OP Units? Like Stock, but Not.
Limited partnership interests in the Operating Partnership are referred to as "OP Units." In the case of Home Properties, an OP Unit Holder is a limited partner in a private partnership, the OP. This is different from the public shareholders, who own stock in a public company (Home Properties, Inc. (HME), the REIT). However, from an economic standpoint, OP Units are indistinguishable from shares of stock in the REIT. OP Units are equal in value to shares of stock in the REIT, and they fluctuate in value in the same way as REIT shares. OP Unit holders also receive distributions equal to the dividends paid on the REIT shares. OP Units are convertible on a one-for-one basis with shares of stock in the REIT, subject to a lock-up period (generally the first year after issuance) during which the OP Unit Holder may not convert them into shares of stock.

Although OP Units and REIT shares are the same from an economic standpoint, they are taxed differently for federal and state income tax purposes. An OP Unit Holder is deemed to earn a portion of the total income of the Operating Partnership, including income from each of the states in which the OP transacts business. As a result, the OP Unit Holder will have income tax filing requirements in each of these states. REIT shares, on the other hand, generate income that is taxable only in the shareholder's state of residency and do not require additional state tax returns to be filed.

UPREIT Deals: Benefits and Key Points

What are the benefits of doing an UPREIT deal?

1. The UPREIT deal allows the owner to dispose of its property in a way that maximizes its value.
2. Unlike a 1031 exchange where the owner would end up with another property (which is not liquid), the owner now has an investment that is much more liquid — OP Units.
3. Gains tax has been deferred. Gains tax would be triggered on conversion of the OP Units into shares of stock, as discussed below.
4. Unlike a cash deal or 1031 exchange, in an UPREIT deal, each individual partner of the selling partnership may elect to receive cash or OP Units as they choose.
5. Unlike a 1031 exchange, the owner will be free of property management concerns.

A few key points to be aware of when doing an UPREIT deal:

1. Accredited Investors - Only "accredited investors" can receive OP Units. When OP Units are issued only to accredited investors, the OP Unit offering will be deemed to be exempt from federal securities laws.
   To be an accredited investor, an owner (or partner who wants to receive OP Units) must meet one of the following criteria:
   • Individual annual income in excess of $200,000
   • Joint annual income with spouse in excess of $300,000 for each of the last two years
   • net worth, individually or jointly with their spouse in excess of $1 million
   • a trust or similar entity having assets in excess of $5,000,000
2. Restriction on Conversion of OP Units during Lock-up Period. OP Units will be subject to a restriction on conversion (sale) for some period of time (usually one year), referred to as a "Lock-up Period." The Lock-up Period is required to preserve the validity of the private placement of the OP Units.
3. Distributions. OP Unit Holders receive distributions equal to the dividends paid on the REIT shares.
4. Tax Impact of Conversion of OP Units into Stock. Conversion of OP Units into shares of stock in the REIT triggers the gain the owner deferred. One nice tax planning feature about OP Units is that they can be converted a few at a time over time so as to spread out the tax impact.
5. Importance of Strength of OP/REIT. The strength of the OP Units is only as good as the strength of the OP and REIT. Therefore, unlike a cash deal, the owner needs to be comfortable that the REIT is stable and profitable.
6. Specialty Transaction. UPREIT transactions are specialized transactions. In addition to being comfortable with the REIT, an owner should consider working with a law firm and accounting firm that have experience with UPREIT deals.

Tax Protection

What tax protection should the owner obtain from the OP?
In the agreement with the owner, the OP will make certain representations to partners receiving OP Units to protect them from future negative tax consequences. There are two specific types of representations:

1. Subsequent Sale of the Property
   The first is referred to as a "No Sale" covenant, meaning that the OP will not sell the property the owner contributed except in a tax-deferred transaction. Let's assume that the owner contributed property in an UPREIT transaction. Later, the OP decides to sell the owner's property. If the OP sells the property in a normal taxable transaction, a majority of the taxable gain realized on the sale would be directly allocated to the former partners of the owner. In essence, the partners would recognize the income that was deferred when the OP purchased the property. In order to protect the OP partners from a taxable event, the OP will agree not to sell the contributed property for a certain period of time (5 — 7 years). If the OP wants to sell within that period, it must do so in a tax-deferred property exchange (1031 exchange) so as not to create gain to the OP partners.
2. Allocation of Partnership Liabilities
   The second important tax provision is a requirement that the OP allocate sufficient debt to OP Unit Holder so as to cover his negative capital account. If the partner is allocated a sufficient amount of liabilities (debt), to cover his capital account, he will not recognize any taxable income. In the agreement, the OP will agree to allocate enough liabilities to the OP partners to cover their negative capital accounts for a certain period of time (5-7 years, can vary depending on the individual capital accounts).

Redemption of OP Units

After the one-year Lock-up Period, OP Units may be converted into shares of stock in the REIT. This is called "redemption" of the OP Units. Redemption is treated as a sale for tax purposes and the gain which was deferred on the original sale will be triggered. The process for redeeming OP Units will be described in the partnership agreement of the OP. Generally in order to redeem OP Units, a partner should contact the OP to complete the necessary conversion forms, and after a notice period, shares of stock will be issued. The conversion price will be based on the average price of the REIT stock for a period of days prior to the redemption.

Obtain Advice

Each transaction is unique and has technical tax and legal issues. Owners are encouraged to consult with their own financial, legal, and tax advisors and to rely on this information only as an option to explore with their advisors.

OP Units are Only as Good as the OP

We encourage owners to review Home Properties' track record of success. We would be happy to meet with owners and advisors to further discuss the benefits of UPREIT transactions.