UPREIT Transaction Can Cut Down on Capital Gains Tax
Tax experts are offering some advice these days to real estate owners and investors who want to divest themselves of property: Don’t sell it to a real estate investment trust.
Instead of selling, experts recommend that owners contribute their property to a REIT--more specifically to a species known as an UPREIT--to defer capital gains taxes.
“UPREIT transactions have become a great exit strategy for people who own real estate that they have acquired, either through investing or in the course of building a business, but who now want to divest themselves of that property,” said Richard Kale, a partner at law firm Greenberg Glusker Fields Claman & Machtinger.
What makes UPREIT deals so appealing to individual investors, small-business owners and large companies alike is the special meaning of the term “contribute” in the context of REIT deals.
Gary Kaplan, another Greenberg Glusker attorney, explained that when an owner or investor “contributes” property to an UPREIT, he or she doesn’t receive cash. Instead, the investor receives UPREIT partnership units equal to the value of the property.
In the eyes of the Internal Revenue Service, that means the transaction isn’t a sale. And because it isn’t a sale, it doesn’t trigger capital gains taxes.
“These transactions have become very popular because it’s possible for a property owner to get back partnership units that are the equivalent value of REIT shares but to do it tax-free. That’s the whole key,” Kaplan said.
An UPREIT, or umbrella partnership REIT, combines a number of existing partnerships or business entities into a REIT in which the partners of those entities become members of a new partnership called the “operating partnership.” An UPREIT typically does not own its property directly but instead owns an interest as the general partner and majority owner of the new operating partnership, whose members initially receive partnership units as their payment for contributing their properties to the deal.
An UPREIT contrasts in a number of ways with a so-called down REIT, in which the REIT typically owns some of its property directly and some in partnerships. The UPREIT has emerged as the REIT structure of choice because it offers a number of tax advantages to the partners who form it and to owners who later contribute their properties to the UPREIT.
Besides deferring taxes, contributing property to a REIT offers two other primary benefits, according to real estate and tax experts.
First, by deferring the capital gains tax it provides what one accountant calls “a tremendous estate planning vehicle” that enables investors to sidestep such taxes during their own lifetimes and reduce or eliminate potential capital gains for their heirs.
Second, it provides a regular cash flow because owners of partnership units receive cash payments equal to the dividends that would be paid on a like amount of REIT stock. That’s because, thanks to the structure of UPREIT deals, each partnership unit is equal in value to one share of the REIT’s stock and provides the same cash flow.
According to tax experts, the estate planning feature of the UPREIT deals is appealing to individual investors because it spares their heirs the burden of capital gains taxes and enables them to raise cash quickly to pay estate taxes.
Kaplan explained that UPREIT deals typically include the provision that the partnership units can be converted into REIT shares, but tax rules provide that an investor who converts the units faces capital gains tax.
However, if that same investor holds onto the partnership units and wills them to his heirs instead of converting them to stock, the heirs can convert them to stock without having to pay the capital gains tax.
“Since the conversion of partnership units to REIT stock is a taxable event, the usual strategy for people who contribute property to a REIT is not to convert the partnership units to stock until there is a death, so that there’s no capital gain,” Kaplan said.
Doug McEachern, partner in charge of western real estate services for Deloitte & Touche, calls this feature of UPREIT deals “a tremendous estate planning vehicle.”
If a husband and wife jointly own property and contribute it to a REIT, they can arrange that upon the death of one, the surviving spouse receives all of the partnership units and is entitled to convert them to stock without facing capital gains tax, McEachern said.
McEachern pointed out that being able to convert the partnership units to stock without any tax penalty is a boon to heirs because they often need to raise cash to pay estate taxes. Generally, partnership units can be converted to REIT stock and sold to pay cash much faster than actual property can be marketed and sold, McEachern said.
“The liquidity of the partnership units is a big advantage,” he said.
The other big attraction of UPREIT deals, their cash flow, is appealing to large companies and individual investors alike, according to some who have contributed holdings to the REITs.
Gary Rossi, chief financial officer at the San Francisco offices of Lincoln Property Co., said the cash flow was one reason Lincoln, a privately held firm, recently contributed 17 apartment buildings to Equity Residential Properties Trust in exchange for partnership units, known in UPREIT jargon as “operating partnership” or “OP” units.
“One of the advantages of converting a portion of our portfolio into OP units is that it’s a way of providing more liquidity and a fixed return that is more equivalent to a dividend,” Rossi said.
Rossi added that the deal will help Lincoln finance future acquisitions and development.
“It gives us the capability of going out to the capital markets and borrowing against the OP units, without suffering the adverse tax consequences of selling the property to raise capital,” Rossi said. “In conventional real estate partnerships, the units are illiquid, but in an UPREIT arrangement, they’re more liquid and you can borrow against them much more easily.”
In another major REIT contribution deal earlier this year, Menlo Park-based REIT Spieker Properties Inc. announced the acquisition of 3 million square feet of office properties from Torrance-based Transpacific Development Co. for $440 million in a combination of Spieker operating partnership units and common stock. The Transpacific portfolio includes Santa Monica Business Park, Marina Business Park in Marina del Rey, Cerritos Towne Center, City Office Portfolio in Orange and a number of other properties developed by Transpacific.
On a smaller scale, partner Harvey Friedman of Greenberg Glusker last year elected to contribute his interest in a private real estate limited partnership to Essex Property Trust, a REIT that specializes in apartment buildings, in return for partnership units in the REIT.
“I am treated just as if I were an actual shareholder in the REIT,” Friedman said. “The REIT is paying about a 6% dividend, so I receive 6% on my money and don’t have to pay what would have been a substantial capital gains tax if I had sold my partnership interest.”
UPREIT transactions are not without their pitfalls, however.
McEachern, Kaplan and Kale all pointed out that anyone contributing property to a REIT should try to negotiate an agreement that protects them if the REIT later decides to liquidate its holdings.
“If you contribute a property to a REIT, and then the REIT decides the next day to sell all of its properties, that would trigger a capital gain for you because you would receive a portion of the proceeds from the sale,” Kaplan said. To avoid this, experts advise owners to negotiate “lockup” agreements that protect them in the event the REIT decides to sell the property they contribute.
Some other caveats from Kaplan and Kale:
* Use due diligence on the REIT. Read its Securities and Exchange Commission filings, find out what properties it owns, who manages them and what deals they’ve made.
* Be careful not to create a taxable transaction by taking cash out of the deal.
* Be aware that these tax advantages are generally available for UPREIT transactions but not down-REIT deals.
“Down REITs are much more complicated and much riskier from a tax standpoint,” Kaplan said.
Another concern for anyone exchanging actual property for partnership units is whether the underlying REIT stock will rise or fall in value, especially because REIT shares in general have declined in value this year. Some market experts believe REIT stocks today are undervalued and will rise in price, while others consider them overpriced and believe they will decline further.
“If you think REIT stocks are high, then you think you’re not getting as many partnership units for your property as you might and you’re expecting them to decline in value,” McEachern said. “But if you think the stocks are undervalued, then you think you’re getting more units for your property and you expect them to rise in value. It’s a question of whether the cup is half full or half empty.”
In either case, he said, UPREIT deals are still a good tool for tax and estate planning.
“In that respect, I think UPREIT transactions make sense in any economic environment,” he said.
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The REIT Race
The following REITs are based in Southern California. The chart shows their closing prices as of July 24, their low and high share prices during the last year and their yield per share.
Ticker July 24 Southern California REITs symbol Exchange close Low** High** Alexander Haagen Properties* ACH AMEX 14.94 13.75 18.25 Alexandria Real ARE NYSE 28.63 24.06 34.56 Estate Equities American Residential INV NYSE 9.13 8.38 16.75 Investment Trust Angeles Mortgage ANM AMEX 18.50 15.00 19.88 Investment Trust Apex Mortgage Capital AXM NYSE 10.75 10.19 15.00 Arden Realty ARI NYSE 25.00 24.88 32.38 Burnham Pacific Properties BPP NYSE 14.69 12.75 15.75 Excel Realty Trust XEL NYSE 28.25 25.94 35.63 G&L; Realty Corp. GLR NYSE 16.88 16.50 21.75 Health Care Property HCP NYSE 36.88 32.75 40.38 Investors IMPAC Commercial Holdings ICH AMEX 14.94 14.00 20.75 IMPAC Mortgage Holdings IMH AMEX 16.38 14.00 18.56 Imperial Credit Commercial ICMI NASDAQ 12.50 12.50 19.13 Mort. Investment INMC Mortgage Holdings NDE NYSE 23.88 21.00 27.19 Irvine Apartment Communities IAC NYSE 28.94 28.06 33.50 Kilroy Realty KRC NYSE 23.56 22.00 30.00 LTC Properties LTC NYSE 17.81 17.19 21.94 Macerich MAC NYSE 28.38 24.75 30.38 National Golf Properties TEE NYSE 29.69 28.13 33.69 Nationwide Health Properties NHP NYSE 23.94 21.81 26.94 Pacific Gulf Properties PAG NYSE 21.31 20.75 24.63 Pan Pacific Retail Prop. PNP NYSE 21.50 19.38 22.75 Price Enterprises PREN NASDAQ 18.81 17.13 20.25 PS Business Parks PSB AMEX 24.31 19.31 26.63 Public Storage PSA NYSE 26.81 26.13 33.63 Realty Income O NYSE 25.44 23.75 27.81 Sunstone Hotel Investors SSI NYSE 12.31 12.25 18.19 Westfield America WEA NYSE 17.38 14.25 18.75
Southern California REITs Yield Alexander Haagen Properties* 9.64 Alexandria Real 5.59 Estate Equities American Residential 12.27 Investment Trust Angeles Mortgage 6.92 Investment Trust Apex Mortgage Capital 9.30 Arden Realty 6.72 Burnham Pacific Properties 7.15 Excel Realty Trust 7.08 G&L; Realty Corp. 9.24 Health Care Property 7.00 Investors IMPAC Commercial Holdings 9.24 IMPAC Mortgage Holdings 11.38 Imperial Credit Commercial 5.20 Mort. Investment INMC Mortgage Holdings 7.83 Irvine Apartment Communities 5.18 Kilroy Realty 6.88 LTC Properties 8.76 Macerich 6.48 National Golf Properties 5.79 Nationwide Health Properties 7.02 Pacific Gulf Properties 7.88 Pan Pacific Retail Prop. 7.07 Price Enterprises 7.44 PS Business Parks 4.11 Public Storage 3.28 Realty Income 7.78 Sunstone Hotel Investors 8.93 Westfield America 8.17
*Will become Center Trust Retail Properties.
Closing share prices of American Residential Investment Trust are compared with performance of the Wilshire Real Estate Securities Index between Nov. 1997 and June 1998.
Wilshire REIT Index: 235.42
American Residential Investment Trust: $9.69
Note: The Wilshire Real Estate Securities Index is a market-capitalization-weighted index of publicly traded real estate securities such as real estate investment trusts (REITs), real estate operating companies (REOCs) and partnerships. The index is made up of companies whose charter is the equity ownership and operation of commercial real estate. The REIT share price return component is displayed in this overview.
Source: Deloitte & Touche