UPREITs - A Real Estate Exit Planning Technique
Real estate investors that hold a substantial portion of their wealth in real estate know that managing income-producing properties can be lucrative, yet a great deal of work. This is particularly true for owners of larger multi-family or commercial real estate properties. If the properties are properly maintained and managed in an area where real estate prices appreciate over time, substantial increases in wealth may occur. For certain owners however, there may come a time in which owning a large real estate position may no longer make sense for a variety of reasons. This can be due to financial or risk concerns including concentration risk, liquidity risk or many other financial factors. Separately, day-to-day issues including management or working directly with tenants can also become taxing over time.
What options does this type of real estate owner have if they’ve done well in managing a select portfolio of these type of properties but it may be time to move on in a thoughtful manner? Particularly, what options may exist if they want to reduce the accumulated investment risk, reduce the managerial burden but retain wealth in the family, yet increase ultimate liquidity while also potentially minimizing the income taxes upon an exit? To achieve all of these outcomes may seem like the perfect outcome to those in this situation. However, while one aspect or another may be accomplished independently, all of these positive outcomes might only occur through proper planning. Selling a property outright to diversify could create a very large tax burden from built up appreciation, depreciation recapture and other tax concerns. Not selling means there is significant concentration risk in this property and a risk of illiquidity or of poor market selling conditions if the owner were to pass away unexpectedly and a sale is forced. A creative solution to provide more flexibility to achieve the desirable outcomes mentioned above may be through the use of an Umbrella Partnership Real Estate Investment Trust (UPREIT) structure.
What is an UPREIT?
An UPREIT is a strategic partnership structure that allows a real estate investor to defer capital gains but often with improved diversification, liquidity, and more strategic tax management (among other possibly benefits). This however all may come at the expense of the ultimate loss of control - which if selling outright was the alternative anyway, may not be such a poor option.
Through an UPREIT, a real estate owner contributes their ownership of the property in question (typically a commerical or series of larger rental properties) to an operating partnership owned by a Real Estate Investment Trust (REIT). The REIT typically is a publicly traded entity and acts as the general partner of the partnership. The original real estate owner receives limited partnership (LP) units of the partnership in return for contributing their property. Thanks to some rules in our tax code, the contribution of property by a partner to a partnership is not generally a taxable event, though certain factors may determine otherwise, so always be certain to receive proper tax advice on this matter. Commonly this structure will incorporate other limited partners from other real estate investments who have also contributed their properties as well into the partnership. This may provide additional diversification as the partnership becomes a fund of various real estate properties, potentially mitigating risk.
What is the benefit to an UPREIT?
The opportunity to use an UPREIT structure can be appealing from several perspectives, with perhaps the most evident being risk management, income tax and estate planning benefits. There are also likely managerial benefits to utilizing an UPREIT. We touch on those potential benefits below.
Risk Management Planning
After accumulating a certain level of wealth and benefits through one or several successful properties, naturally reducing risk may be a preference and an exit could be desirable. An UPREIT strategy can shift some of that risk away from one or a few properties and into a pooled investment fund, where risk is less concentrated and diversification may be increased. Aside from potentially better risk management from an investment perspective, increased liquidity may better manage overall risk as well.
Income Tax Planning
The LP holders typically only incur income tax on the embedded gain of the contributed property when exchanging their LP units for shares of the parent REITs security. In a redemption, the parent REIT may also just issue cash equivalent to the value of the REIT’s publicly traded shares in return for the LP units. While the tax implication can still be prohibitive upon sale, the easier access to liquidity by redeeming more liquid REIT shares can be attractive. Further, while the gain still exists and retains its character, it may be possible for only a portion of the gain needs to be realized in order to capture some proceeds. If the property were held outright (rather than through this UPREIT structure), a sale of the property would yield a complete income tax realization event unless a 1031 exchange were utilized (which would only delay the inevitable, not provide a solution to the problem). The value of increased tax management flexibility should not be understated from a planning perspective.
From an estate planning perspective, the heirs and beneficiaries of the LP holder receive three potential benefits that would otherwise not exist absent the UPREIT strategy.
The heirs receive liquidity that they wouldn’t have if the real estate was still held directly. This can allow more equitable and efficient distribution of family wealth to heirs.
If the decedent’s estate owed federal or state estate tax, the existence of liquid shares in real estate is a valuable option for many to better satisfy any tax obligations and preventing a fire sale of the underlying real estate itself.
Lastly, assuming the UPREIT interest was not held in other trusts preventing estate inclusion, the LP interests all receive a step-up in basis at the time of the decedent’s death. This means that for federal (and often state) income tax purposes the tax basis of the underlying property will be marked up (or down) to the fair market value at the LP owner’s date of death. If the property had been greatly appreciated (which is one of the reasons you would use an UPREIT strategy to begin with), this will offer tax savings and a real increase in overall family wealth retention.
In addition to all of the financial planning considerations above, sometimes an added benefit is the ability to transfer managerial duties and oversight away from the original owner’s responsibility. Most times, for a property where an UPREIT strategy makes sense, a management company may already be in place. Nonetheless, managing that management company can be taxing for an owner and being able to shift that duty elsewhere may be a welcomed reprieve. Further, if the next generation of family has no interest in managing the property or has not proven to be competent in this area, being able to shift that responsibility to the parent REIT may be an additional attractive factor.
What to Keep in Mind
Proper due diligence of the parent REIT involved and their portfolio is essential before engaging in this strategy. The management of property by the REIT may be completely different than before which can yield different investment results and cash flow opportunities. Be sure to have done your own research as well as engaged the guidance and counsel of qualified financial, tax and legal professionals.
Understand the costs - either explicit or implicit. Some costs may be required based on the transaction itself, while others may trail into the future after the deal.
Understand that there are often lock-up periods when engaging in an UPREIT. Often times, a new limited partner may have to wait a year or longer before even being able to liquidate a portion of their units. With this comes a risk that your market may turn and just as one may have been interested in an UPREIT for the general benefits of diversification purposes, they must also bear the downside of being exposed to a pool of other investors they previously were not.
Family considerations must be seriously evaluated before engaging in this strategy. As touched on above, when the next generation is not interested or is incapable of managing or overseeing management of the property, an UPREIT could make sense. When they no longer want management responsibilities but want to retain a recurring income or equity stake – an UPREIT can also be a suitable solution.
If there is a pre-exisitng management succession plan for the properties in question, an UPREIT may not be prudent either.
If the property has significant sentimental value and is preferred to be kept exclusively within in the family an UPREIT may not be the right solution purely for personal reasons.
An UPREIT strategy can permit unique opportunities for concentrated real estate owners. It allows for succession opportunities, enhanced risk and investment management, tax planning and increased estate administration ease. That being said, it does involve a certain level of wealth existing within a real estate and a loss of control must naturally be acceptable by the investor to engage in this strategy. However, if the stars align properly and the appropriate REIT owner exists, this can be a very powerful planning and wealth retention technique. For further questions on this and other real estate planning strategies we encourage you to consult with a qualified team of financial, tax and legal professionals and advisors. Please reach out to us with any questions you may have on this topic or schedule a call here.
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