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UPREIT Transaction Can Cut Down on Capital Gains Tax

Trends: Contributing property to such trusts, rather than selling, is gaining popularity.

July 28, 1998|BOB HOWARD | SPECIAL TO THE TIMES

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.

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