A REIT (short for “Real Estate Investment Trust”) is a corporation with special tax treatment that combines the capital of many investors to acquire and/or provide financing for all forms of real estate. A REIT is in many ways like a mutual fund for real estate with investors obtaining the benefit of a diversified portfolio under professional management. Also similar to mutual funds‚ REIT’s do not pay tax at the corporate level‚ meaning there is no “double taxation” of the income to shareholders. In exchange for this special tax treatment‚ the REIT must comply with several requirements‚ one of which is that the REIT must distribute nearly all of its net annual income to shareholders.
The partners of the operating partnership (“OP Unit Holders”) are former property owners who took part in an “UPREIT transaction.” In an UPREIT transaction‚ property owners contribute their properties in exchange for ownership units in the operating partnership (“OP Units”).
The UPREIT structure allows for UPREIT transactions‚ and UPREIT transactions provide an attractive tax deferred exit strategy for owners of real estate who will recognize a significant taxable gain in a cash sale of a highly appreciated property with a low tax basis. If real estate is sold or contributed directly to the REIT‚ it would result in a stepped-up cost basis in the property for the REIT and a taxable event for the contributing property owner. However‚ by contributing the property to the operating partnership instead of the REIT‚ the contributing property owner’s historical cost basis is maintained.
Indeed‚ the primary incentive for a selling property owner in entering into an UPREIT transaction is that it can be completed on a tax deferred basis. Again‚ the owner of the property being contributed to the operating partnership does not recognize immediate gain on the transaction because the owner does not acquire shares of stock in the REIT‚ but rather receives OP Units in the REIT’s operating partnership. In addition‚ if the OP Units end up in the owner’s estate‚ the ultimate recipients of the OP Units will receive a stepped-up basis equal to the value at death and the inherent gain resulting from the UPREIT transaction will not be subject to capital gains or income tax. The tax deferral or avoidance‚ as the case may be‚ gives REIT’s utilizing the UPREIT structure a large advantage over cash purchasers of real estate.
While tax deferral/avoidance may be the primary incentive to entering into an UPREIT transaction‚ there are many other great benefits for selling property owners as a result of completing an UPREIT transaction. See the “Summary of Benefits” listed below.
The term UPREIT (short for “Umbrella Partnership Real Estate Investment Trust”) refers to an entity structure that has been used by REIT’s since 1992 to allow selling property owners the ability to convert their ownership of one or more of their specific real estate properties into an interest which is‚ immediately‚ or can ultimately be converted into‚ a private or public security.
In the basic UPREIT structure‚ all REIT properties are acquired and owned directly or indirectly by its “umbrella partnership.” The umbrella partnership is the entity through which the REIT operates and collects all income from the properties‚ which is why the umbrella partnership is commonly referred to as the “operating partnership.” Thus‚ the REIT does not directly own any real estate properties in the UPREIT structure‚ rather it owns substantial interests in the operating partnership by being both its sole general partner and one of its limited partners.
In the case of our structure‚ Broadstone Net Lease‚ Inc. is the REIT and the managing member of Broadstone Net Lease‚ LLC‚ which is the “operating company” of the REIT.
- Provides a viable tax deferral/avoidance exit strategy to property owners facing significant capital gain tax liabilities on the sale of appreciated property with a low tax basis
- Diversification of real estate holdings (i.e., OP Unit Holders have an interest in a portfolio of properties instead of just one)
- Potential to convert liquid‚ long-term assets (i.e.‚ real estate) into more saleable securities (i.e., OP Units → REIT Share → Cash)
- No property management responsibilities or concerns
- Quarterly income distributions
- Potential to recognize unrealized gains as earnings
- Professional management and expertise in capital markets
- Avoids risk of negative cash flow
- Estate simplification
- Allows the owner to dispose of its property in a way that maximizes its value
- Improved cash position through potential leveraging of OP Units
One of the more notable benefits of an UPREIT transaction is that‚ in becoming an OP Unit Holder‚ the property owner essentially converts an interest in one or more specific properties into an interest in a larger and more balanced portfolio of properties. The operating partnership’s portfolio is often diversified as to property type and geography‚ and usually benefits from the economies of scale and management that a larger entity can offer.
Also noted as one of the more important benefits of an UPREIT transaction‚ is that such a transaction allows an interest in liquid real estate properties to become more easily saleable. This is because OP Units may be converted‚ subject to minor restrictions‚ on a one-for-one basis for shares of common stock of the private or publicly-traded REIT. While such a conversion to stock may trigger recognition of taxable gain‚ the flexibility permits the owner to unlock value and access capital as needed.
The capital gain taxes remain deferred as long as the operating partnership holds the property and the OP Unit Holder holds the OP Units. In other words‚ capital gains taxes become due if: (a) the OP Unit Holder exchanges the OP Units for REIT shares; (b) the OP Unit Holder exchanges the OP Units for cash; or (c) the subject property is sold by the operating partnership. In the last instance‚ however‚ the operating partnership can sell the property as part of a 1031 exchange and avoid the trigger of gain to the OP Unit Holders that contributed the property being sold.
As mentioned above‚ if the OP Units are owned at the time of death of an OP Unit Holder‚ there would be a step-up in basis eliminating any taxable gain which existed prior to death. Thus‚ REIT’s with long-term holding periods‚ such as Broadstone Net Lease‚ Inc.‚ often provide OP Unit Holders with the best long-term tax deferral or a tax planning period.
One nice tax planning feature about OP Units is that they can be converted over time so as to spread out and lessen the tax impact. Also mentioned above‚ OP Unit Holders have the right to convert their OP units into REIT shares on a one-for-one basis. Conversion from OP Units to REIT shares is considered a taxable event‚ so the investor may choose to convert over time‚ which enables the investor to incur any tax liability in smaller increments.
From an economic standpoint‚ OP Units are indistinguishable from shares of common stock in the REIT. OP Units are equal in value to REIT shares and fluctuate in value in the same way. OP Unit Holders also receive distributions equal to the dividends paid on REIT shares. However‚ one difference between the two is that OP Units and REIT shares are taxed differently for 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 it transacts business. Thus‚ OP Unit Holders have income tax filing requirements in each state the operating partnership transacts business. REIT shares‚ on the other hand‚ generate income that is taxable only in the shareholder’s state of residency‚ which means only one state tax return must be filed. Another difference between the two is that OP Units do not carry the same voting rights as shareholders in the REIT because OP Unit holders are not owners of the corporation.
While the economics are the same‚ the OP Unit Holders can not vote like shareholders of the REIT because they are not owners of the corporation.
As mentioned above‚ OP Units are convertible on a one-for-one basis with shares of stock in the REIT. However‚ REIT shares essentially determine the value of OP Units. The price of common stock for a publicly traded REIT is valued by the marketplace. The price of common stock for a private REIT is generally established by its board of directors‚ but it is valued ultimately based upon the quality of the real estate assets it acquires.
OP Unit Holders receive distributions equal to the dividends paid on the REIT shares.
REIT’s will typically facilitate the exchange of OP Units for REIT shares or for cash‚ either by purchasing the OP Units itself or by arranging sales to third parties. However‚ property owners contemplating the use of an UPREIT transaction should plan on a long-term hold (e.g.‚ 5-7 years) of the OP Units in order to make full use of the tax shelter they provide.
Yes‚ in certain conditions‚ OP Units may be pledged as collateral for a borrowing by the OP Unit Holder‚ thereby achieving some further liquidity while still maintaining the tax deferral.
OP Units Holders must be “accredited investors” in order for offering of OP Units to be exempt from federal securities laws. To be an accredited investor‚ a property owner (or partner therein) must meet one of the following criteria:
- Individual annual income in excess of $200‚000; OR
- Joint annual income with spouse in excess of $300‚000 for each of the last two years; OR
- Net worth in excess of $1 million (individually or jointly with spouse); OR
- Trust or similar entity having assets in excess of $5‚000‚000.
An UPREIT transaction makes sense if a property owner is looking to achieve one or more of the following: (a) defer capital gains tax when appreciated real estate is sold; (b) eliminate management hassles of owning real estate; (c) diversify through ownership of a portfolio of properties; (d) upgrade to institutional quality real estate; (e) receive consistent quarterly income. In addition‚ the following real estate holdings are good candidates for an UPREIT transaction:
- Family-owned properties with unresolved succession issues
- Properties with third-party tenants
- Partnerships that need to be dissolved
- Long-term assets with very low basis
- Surplus property generated by consolidations
- Property owners concerned they have too much of their net worth tied up in real estate
Tax-deferred Method #1: 1031 Exchange
Perhaps the most well-known way for an owner of real estate to defer the tax on capital gain is to exchange the real property for another real property in a “1031 exchange” (after Section 1031 of the Internal Revenue Code). In a 1031 exchange‚ the property being sold in the exchange is referred to as the “relinquished property” and the property being acquired in the exchange is referred to as the “replacement property.” According to IRS requirements‚ within 45 days after the sale of the relinquished property‚ the owner must identify the replacement property. Once identified‚ the owner must acquire the replacement property within 180 days after the sale of the relinquished property. Thus‚ the property owner faces challenging time frames to identify the replacement property and to negotiate and close the sale and the purchase. And because the owner has sold one property and acquired another‚ there will be no change in liquidity and likely no change in property management responsibilities.
Tax-deferred Method #2: 721 Exchange / UPREIT Transaction
A viable‚ tax-deferred alternative to a 1031 exchange is what is known as a “721 exchange” (after Section 721 of the Internal Revenue Code) or “UPREIT transaction.” As described in this memorandum‚ in an UPREIT transaction‚ a property owner contributes its property to the operating partnership of a REIT in exchange for OP Units. The same tax deferral is achieved as in a 1031 exchange‚ but with more benefits.