A Real Estate Investment Trust (REIT) is an entity that combines the capital of many investors to acquire, manage, develop and/or provide financing for all forms of real estate. If REITs comply with certain guidelines, they do not pay tax at the corporate level. Among these guidelines is that REITs must pay out at least 90% of their taxable income as dividends to shareholders.
An Umbrella Partnership Real Estate Investment Trust (UPREIT) refers to an entity structure that allows selling property owners the ability to convert their equity ownership in real estate properties into an equity interest in a REIT’s subsidiary on a tax deferred basis.
In a typical UPREIT structure‚ all REIT properties are purchased and owned directly or indirectly by its “umbrella partnership” (also referred to as an operating partnership (OP)). The properties are operated and managed within the OP, of which the REIT serves as the sole general partner as well as a significant limited partner. In the case of our structure‚ Four Springs Capital Trust is the REIT and the sole general partner of Four Springs Capital Trust Operating Partnership, L.P.‚ which is the operating partnership of the REIT.
An UPREIT transaction is similar to a sale of real estate for cash. In an UPREIT transaction, an owner of real estate contributes their interest in real estate to the operating partnership in exchange for OP Units instead of cash. In addition, in an UPREIT transaction the seller is allocated a certain dollar amount of debt of the operating partnership for tax purposes. See “How are partnership debts allocated?” below.
The capital gain taxes remain deferred as long as the UPREIT retains the asset(s) and the Unit Holder holds the OP Units. In other words, a Unit Holder will incur capital gains taxes if: (a) the Unit Holder exchanges the OP Units for REIT shares; (b) the Unit Holder redeems their OP Units for cash; or (c) the subject property is sold by the operating partnership. In many cases, however, the operating partnership will sell the property as part of a 1031 exchange and avoid triggering the gain on the contributed property.
OP Units have similar economic characteristics as REIT shares. In addition, an OP Unit holder may receive distributions that are similar or equal to the dividends paid on REIT shares.
The distribution that the OP Unit holder receives is viewed as a percentage of the income generated by the operating partnership. Given that the UPREIT owns and manages properties in multiple states, a Unit Holder may have income tax filing requirements in each state.
Also, OP Unit Holders have more limited voting rights that REIT shareholders since Unit Holders own an interest in the partnership and not in the REIT.
For an offering of OP Units to be exempt from federal securities law, the owner must be an accredited investor. To qualify as an accredited investor, a property owner must satisfy one of four criteria:
There are many reasons why a property owner might want to pursue an UPREIT transaction. Several of the more common motivating factors that would make a property owner a good candidate for an UPREIT transaction are listed below:
Unlike a 1031 exchange, once a property owner takes OP Units in return for selling an asset, they can not exchange that Unit back into an equity interest in an individual property. UPREIT units can only be converted into shares of the REIT, which creates a taxable event. However, unit conversion is at the owner’s discretion; giving the holder control over the timing the conversions and tax payments.
Also, OP Unit Holders have more limited voting rights than REIT shareholders since Unit Holders own an interest in the partnership and not in the REIT.
Depending on how the note is written, in many cases the mortgage on a property that an owner wishes to sell to the operating partnership is assumable. If the mortgage debt has been outstanding for at least two years at the time of the transaction, then the mortgage debt generally will constitute a qualified liability and not be regarded as a “disguised sale”. On the other hand, if the mortgage debt was incurred in the prior two years, then its characterization for disguised sale purposes may depend on how the borrowed funds were used. If the proceeds were used to invest in the property or to refinance debt on the property, then the mortgage debt generally will be a qualified liability and not considered a disguised sale.
As a partner in the Operating Partnership, an OP Unitholder will receive an allocation, for income tax purposes, of the liabilities of the Operating Partnership. An OP Unitholder’s adjusted tax basis in his or her OP Units will be increased by the amount of such allocation. Among other things, an increased tax basis from an allocation of liabilities may enhance an OP Unitholder’s ability to (i) receive cash distributions in excess of earnings on a tax-deferred basis and (ii) absorb and use net losses, if any, generated by the Operating Partnership.
Four Springs Capital can structure an UPREIT transaction that fits the financial/tax needs of most clients. However, to the extent that a seller receives cash as a portion of the consideration, certain federal and state tax liabilities may be triggered.
Absolutely! Every individual’s legal, financial and tax situation is unique, and the tax issues related to UPREIT transactions can be complex. Asset owners are encouraged to obtain expert tax and legal advice before finalizing the sale of property to an UPREIT.