Special REIT structures

An Umbrella Partnership Real Estate Investment Trust (UPREIT) allows property owners to contribute to an operating partnership (OP), which is owned by the REIT, in an exchange for partnership interests in the OP. All activities are performed at the OP level. This is generally a tax-deferred transaction under Section 721. 

Under Section723, the OP acquires contributed property with a carryover basis and, under Section 722, the contributor’s tax basis in the OP interests received is equal to its tax basis in the property contributed, adjusted for debt. At the time of contribution, depreciation and built-in gains will generally be specially allocated to the contributor under Section 704(c). 

The UPREIT structure has both advantages and disadvantages.  It allows for the avoidance of Section 351(e) and Section 721(b) on contribution of property; and acts as a substitute for like-kind exchanges. There is also liquidity due to the redemption rights for cash or REIT stock. However, an exchange of OP units for REIT stock is deemed a taxable transaction.  

An alternative, comparatively new structure is the DownREIT. In a DownREIT, the real estate investments are held directly by the REIT or through lower tier partnerships that are formed between the REIT and the property owner. The lower tier partnerships can own and operate real estate properties. 

DownREITs have both advantages and disadvantages. Properties are acquired on a tax-deferred basis however, structurally, there is a lack of central ownership, which can increase the administrative burden and recordkeeping. There are also risks of disguised sales that could trigger gain for the contributor as well as risks of the lower tier partnership interests being recharacterized as REIT stock, which would be immediately taxable to the contributor. 

Baby REITs are also becoming increasingly popular. A baby REIT is a subsidiary of a parent REIT, with both the parent REIT and baby REIT having to pass the various REIT tests independent of one another, including the 5-or-fewer and 100-shareholder tests. By using such structuring, the parent REIT has a single asset - baby REIT stock. This is advantageous for those with foreign or tax-exempt investors because they can invest in a single entity, rather than numerous entities. 

Tax-exempt investors may wish to own real estate through a REIT, because dividend income generally does not constitute unrelated business taxable income. Furthermore, foreign entities that invest in US real estate via a “domestically controlled” REIT are not taxed on the sale of REIT stock.   

For example, a REIT that acquires a 100+ portfolio of properties analyzes and then groups those that will be marketed and potentially sold together. Each of these smaller portfolios are then contributed to a separate baby REIT. This structure allows increased flexibility with regards to the number of sales that a REIT is permitted to make in any given year. Each baby REIT is permitted up to seven sales under the prohibited transaction safe harbor as opposed to only seven sales across the entire 100+ portfolio had it been owned by only one REIT. In addition, foreigners will have an increased interest in purchasing these smaller portfolios via REIT stock. As mentioned above, foreign entities are not taxed on the sale of REIT stock of a “domestically controlled” REIT. 

If the types of tax structuring discussed above could be of value to you, or someone you know, reach out to Mazars for additional information.

The information provided here is for general guidance only, and does not constitute the provision of tax advice, accounting services, investment advice, legal advice, or professional consulting of any kind. The information provided herein should not be used as a substitute for consultation with professional tax, accounting, legal or other competent advisers.