Smaller real estate owners can now get many of the benefits previously only available to institutional investors.
A new twist on the traditional UPREIT is gaining popularity — the DST to UPREIT transaction.
The Delaware Statutory Trust (DST) structure has become a powerful tool for making tax advantaged real estate investments under Section 1031 of the Internal Revenue Code, which defers taxes when real estate owners sell and reinvest in qualifying replacement property.
The desire for higher quality replacement property with turn-key management is the driving force behind the movement to DST replacement property, especially among older real estate owners who are tired of property management.
There are, however, many structural requirements for a DST to qualify for tax deferral under Section 1031. For example, DST properties must be sold when their mortgage matures, and it’s not permissible to recapitalize or refinance, even when it would be in the best interest of investors. Thus, most DST properties must be sold every ten years (when their mortgage matures), even if the owners are happy with their investment or it’s an inopportune time to sell.
The DST structural issues, and a number of additional REIT benefits, are leading to a new phase — where DST owners contribute their interests to an UPREIT.
Umbrella Partnership Real Estate Investment Trust (UPREIT). Most REITs own their real estate in an operating partnership that qualifies for favorable partnership taxation. In an UPREIT transaction, owners contribute their real estate to the operating partnership in exchange for operating partnership (OP) units. The same applies for owners of DST interests.
A number of favorable partnership tax rules apply. For example, there is no taxable gain to the contributors (the property or DST owners) or the recipient (the operating partnership) under Section 721. The operating partnership may assume the contributor’s mortgage debt or repay it. Contributing owners retain their tax benefits, including depreciation and operating expense deductions.
Importantly, UPREIT transactions allow owners to exchange one property (or interest in a DST) for ownership in a larger diversified operating partnership portfolio that is professionally managed by the REIT and obtain other REIT benefits.
REIT Benefits. REITs provide a high degree of transparency: typically, a majority of the board is comprised of independent directors, the board approves major decisions and sponsor compensation, and financial statements are audited by a top CPA firm.
REITs provide a liquidity option that is not available under the DST structure. OP holders have an option to exchange OP units for REIT stock that can then be sold, thereby creating liquidity. There is no liquidity in a DST program until the DST’s property is sold (typically up to ten years).
Also, the UPREIT structure is beneficial for estate planning and gifting because OP units can be divided and distributed to heirs or partners. Then, each individual OP holder can make their own decision whether to hold, gift or sell some or all of the OP units. The UPREIT structure provides maximum flexibility for estate and gift planning.
Section 1031 does not permit a direct exchange into an UPREIT. To comply, a two-step process is required: first, a Section 1031 exchange into a DST and, later, a DST to UPREIT transaction.
Potential Benefits of a DST to UPREIT Transactions:
- Increased Distributions: Distributions typically increase based on appreciated value of the DST property being contributed.
- Safety Net/Diversification: DST owners have the safety net of a more diversified investment because the REIT owns a much larger portfolio.
- Ability to Capture Future Appreciation: Many DST properties would benefit from additional capital improvements to further increase value beyond funds held in reserves.
- Transparency: REITs typically provide a high degree of transparency.
- Liquidity: OP holders have an option to sell OP units, thereby creating liquidity that is not available in a DST structure.
- Retention of Tax Benefits: OP holders retain their tax benefits, including depreciation and other tax deductions.
- Long-Term Hold: Properties can be held long-term versus a sale when the mortgage matures.
- Ability to Assume Favorable Long-Term Debt: Ability to assume favorable DST loans.
- Lower Fees: Lower fee structure to manage and operate.
- No Taxable Gain: These benefits are accomplished without any taxable gain (federal or state) under Section 721.
New structures evolve over time. The DST to UPREIT transaction allows investors to upgrade their single property DST investment for an interest in a diversified portfolio of investment grade real estate along with other REIT benefits, all in a tax-advantaged manner. This progression is affording smaller real estate owners many of the benefits previously only available to institutional (REIT) investors. The DST to UPREIT transaction is the next phase in the progression and institutionalization of real estate. This is an exciting time to be in the real estate business.
Louis J. Rogers is founder and co-chief executive officer of Capital Square