Brokers & Sellers > Tax Deferred/UPREIT

Tax Deferred/UPREIT

The Modern Way to Own Real Estate

The Problem

Selling an investment property today is a relatively simple thing to do.

The hard part of the transaction is keeping the proceeds.

Surprisingly, the largest portion of sale proceeds often does not go to the owner (seller) of the property, it is payable to the government in the form of taxes.

Even with the latest capital gains tax revisions by Congress, it is demonstrated that over one-half of the seller's sale proceeds may be needed to pay Uncle Sam. Up until now, this means that a seller, who for a variety of reasons needs or wants to sell, has one of only three choices:

• Sell the property for cash or a combination of cash and purchase money mortgage. This means paying gains taxes, often more than one-half the proceeds, and/or risking that the buyer will actually make the mortgage payments.
• Sell the property but do an IRS code 1031 tax deferred exchange for another property. This presupposes that the seller wishes to acquire other real estate and in fact can find some other property that fits the parameters of that particular transaction. This is easy to contemplate in concept but a more difficult thing to accomplish given government time limitations and other restrictions regarding qualified property etc. This also means that the seller wishes to risk owning someone else's real estate rather than his own.
• Keep the property. Inherent in this choice are the following possible drawbacks:
  • lack of liquidity
  • maintenance
  • management
  • ongoing capital improvement/rehab necessary
  • minimized further appreciation
  • risk to that particular economic market
  • lack of ongoing tax benefits/potential phantom income
  • increasing tax liability due to further basis reduction

If a property owner retains ownership until death, heirs will receive a step-up in the basis so that the estate can then sell the property without incurring any capital gains taxes. Unfortunately, this is not always the ideal time or circumstance to sell a property, and rarely generates the property's full potential market value. Also, the estate must continue to manage the property, probably with personnel that have little or no experience.

The Solution

The new real estate currency that solves the above problem(s) is called an UPREIT transaction. It provides liquidity and diversification for property owners and allows freedom from day-to-day management responsibilities. Yet, no taxable gain is triggered, so that a low (or even negative) tax basis can be preserved. It is an innovative solution that is gathering momentum in the real estate industry.

Simply stated, the UPREIT is a REIT (Real Estate Investment Trust) that owns a controlling interest in a partnership that owns real estate. UPREIT means "Umbrella Partnership Real Estate Investment Trust". The umbrella partnership is also referred to as an operating partnership (OP), since all or most of the operations take place at the partnership level. It usually consists of the following:

• the general partner of the OP is a REIT, (usually publicly traded) that issues one share of stock for each general partner and limited partnership unit it holds in the OP; and
• other holders of limited partnership units, commonly referred to as OP Units, have the right to exchange their OP units for shares of the stock in the REIT at any time on a one-for-one basis. Such exchanges for stock are taxable at the time exchanged and therefore all gains taxes are deferred until the OP UNIT HOLDER decides to sell all or part of the units held. If the holder retains the units in their estate, the gains taxes can be eliminated completely.

The Reasons

The UPREIT structure is designed to provide a way for the owner of investment real estate to exchange his interest/equity in real estate for the many benefits of owning an interest in a large and diversified public real estate company, all without having to pay any tax on capital gains. This is similar to a 1031 tax deferred exchange without the inherent problems of trying to accomplish one. It also means the seller of the real estate does not have to deal with the ongoing problems of owning the same or other real estate.

The owner/seller gains the following advantages in becoming a "Home Properties" OP unit holder:

• Diversification - Home Properties owns or manages multiple properties, currently over 50,000 apartments, in geographically diverse locations, thereby spreading the risk.
• Professional management - Home Properties is self-managed and has knowledgeable, trained professional property and asset managers on staff to assure that each property achieves its full operating potential.
• Increased cash flow - Home Properties distributes 80% to 90% of cash flow as quarterly dividends to its shareholders and OP unit holders, with a portion of the dividend not currently taxable.
• Security - Home Properties has a low debt to market capitalization ratio (presently about 45%), providing security in the form of low leverage primarily at fixed interest rates so cash flow is not significantly affected in the event of interest rate fluctuations.
• Liquidity - As a holder of OP units, the unit holder has the right to exchange units for REIT shares that can be readily sold on the open stock market.   Without having to exchange the OP units for shares and then selling the shares, lending institutions view OP units as assets against which they will loan money on attractive terms.
• High Total Returns - The seller continues to earn an investment return on full equity value--not just the net proceeds after tax that would be received upon sale.
• Tax Shelter - Cash distributions exceed taxable income allocated to unit holders.
• Inflationary Hedge - Rent increases and property expense control help create property portfolio appreciation.
• High Cash Returns - Relative to other investment alternatives.
• Price Appreciation - Resulting from both internal growth and external growth, as the REIT continues to acquire additional properties which generate returns in excess of its cost of capital.

Example of Sale Using UPREIT Exchange

In this example, Federal and assumed State Tax consequences of a cash sale are compared to an UPREIT sale. Assume a 440 unit apartment owner sells a community for $35,000,000 ($80,000/unit) which was held in the family or partnership for many years. The community originally cost $20,000,000 to build or acquire, has a current mortgage of $12,000,000 and is depreciated on the owner’s books to $10,000,000.

Assuming the property is held at least 12 months, the Federal capital gains tax rate is 15% which is the increased value over and above the depreciated cost. An example of tax due upon sale is as follows:

	CASH SALE	UPREIT SALE
Sale Price	$35,000,000
Basis	$10,000,000
Taxable Gain	$25,000,000
Capital Gain Tax Rate (1)	x 20%
Capital Gain Tax	$5,000,000
Tax Due(2)	$5,000,000	- 0 -
Sale Price	$35,000,000	$35,000,000
Mortgage	($12,000,000)	($12,000,000)
Total Tax Due	($5,000,000)	- 0 -
Net Proceeds/Sale	$18,000,000	$23,000,000 (3)

(1) Assumes 15% federal and 5% state, states may vary.
(2) Portion of gain also may be subject to recapture at ordinary income tax rates or unrecaptured Section 1250 gain tax rates.
(3) Paid in the form of OP units.

The result in the example shows that the seller retains much more of the net proceeds than in a similar cash sale taxable transaction.

The "cash sale" portion of the above example is indicative of potential transactions that ultimately have not been made due to the loss of the owner's economic value. In effect, the current tax structure provides owners with an incentive to hold property until death to avoid capital gains tax.

Instead, if the owner exchanges their interest in the real estate with an UPREIT for OP Units, capital gains tax is deferred (or permanently avoided) and the seller retains full economic value as $23,000,000 of OP Units are received in exchange for the owner’s equity.

As a further advantage, the dividend from the OP Units may be higher than the cash flow from the property. If, for example, the $12,000,000 mortgage were originally $15,000,000, with 25-year amortization at 8% interest, annual debt service would be $1,390,000. Assuming NOI before capital expenses from the property is $2,625,000 based on a 7.5% cap rate and 10% of the property's NOI ($262,500) was required for capital improvements each year, this would leave cash flow after cap-x and debt service of $972,500. On the other hand, the Home Properties dividend at today's rate of $2.48 per share on the $23,000,000 of OP Units would be $1,426,000.

$23,000,000 proceeds/$40 share price = 575,000 OP Units x $2.48 = $1,426,000.

Further, if the share price were to increase at only 3% per year, the overall return on the "$23,000,000 invested" would be over 9%, depending upon the degree of stock appreciation.

Cash Flow Example

OWNED
NOI	$2,625,000
Debt Service	(1,390,000)
Cap X @ $656/unit/year	(262,500)
Cash Flow	$972,500

UPREIT Sale
Equity In OP Units	$23,000,000
Shares Owned @ $40.00 Approx.	575,000
	x 2.48
Dividend @ $2.48/share	$1,426,000
Cash Flow If Owned	(972,500)
Additional Yearly Profit	$453,500

UPREIT Exchange for Estate Planning

The estate planning benefit from an UPREIT exchange is demonstrated below by adding estate tax to the above example as follows:

	Cash Sale	UPREIT Sale
Net Proceeds from Sale	$18,000,000	$23,000,000
Estate Tax - 50% assumed	9,000,000	11,500,000
Net Available to Heirs	$9,000,000	$11,500,000

One could argue that the heirs could realize the same net amount as received from an UPREIT sale if the property had been held by the owner and passed on to the estate. This argument is valid, provided the estate managers are as astute and diligent as the original owner would be in obtaining the most favorable price for the real estate. As often happens, however, heirs of real estate become anxious to receive their shares of the estate, or become pressured to pay estate taxes, which results in the real estate being sold by the estate on a "fire sale" basis in what may also be a poor real estate market resulting in a lower price for the real estate. On the other hand, if the estate holds OP units, the OP units can be converted to shares of stock in full or in part, which may be sold to pay estate taxes with the balance distributed to heirs who can individually elect to sell or hold the shares. The heirs receive a step-up in basis so capital gains tax is avoided entirely. The fair market value, which is used for estate valuation of OP units, is set on the date of death based on current market value of the stock which avoids the costly need to have real estate appraised for estate tax purposes.

Estates are often poor property managers which could lead to a decrease in property value if real estate is held in an estate for a long period of time. Site level employees and residents may leave if the future of the property is uncertain.

In summary, an estate will be financially advantaged if the seller of real estate completes an UPREIT exchange instead of selling for cash. The UPREIT exchange before death may result in a larger estate than if the property is not sold, while also greatly simplifying and accelerating the estate management and liquidation process, which could avoid conflicts among heirs.

Other Advantages of Holding OP Units

In addition to the advantages cited above for exchanging real estate for OP Units, there are other more subtle benefits of holding OP Units that offer flexibility. OP Units may be gifted and then exchanged for stock and sold based on the individual wishes of unit holders. Appreciated securities may be particularly useful in making charitable contributions, subject to various tax consequences. A donor advised fund could be an efficient conduit for transferring the value of OP units to multiple charitable organizations.

As a Retirement Plan

By converting the equity in real estate to OP units through an UPREIT transaction, a seller not only avoids huge taxes, they retain and put to work all of the equity from the property. Upon death, the estate receives the property at a much higher basis than if sold outright. The beneficiaries of the estate may, based upon the step-up in basis, tender the units for cash or common stock without paying income tax. This is because the gain on the real estate (OP units) is forgiven at death and the estate takes over at the then market value of the OP units.

Special Situations

Due to the complexity of Federal and State tax laws, every transaction has special features and technical issues. Each individual has a unique tax position. For this reason, property owners wishing to take advantage of an UPREIT structure are encouraged to consult with their financial, legal and tax advisors and to rely on this information only as options to explore with their advisors.

In Summary

An old real estate axiom is that there is a time to buy, a time to hold and a time to sell. A smart owner knows when it is time to sell, optimize profits and move on.

Now with a Home Properties UPREIT transaction, there has never been a more viable time to sell or a more prudent decision to make than to go UPREIT!