Understanding the tax considerations for Real Estate Investment Trust (REIT) roll-ups and initial public offerings (IPOs) is crucial for maximizing investor returns and ensuring regulatory compliance. REITs offer significant tax advantages, but the consolidation of properties or going public can introduce complex tax issues. Proper planning can help minimize tax liabilities, optimize dividend distributions and maintain your REIT’s tax-advantaged status, ultimately enhancing the investment’s value and appeal.
What is a REIT Roll-Up Transaction?
A REIT is a corporation that meets specific tax requirements and elects to be taxed as a REIT. A REIT roll-up transaction, therefore, typically involves merging smaller real estate entities or assets into a larger REIT. During an IPO, a new corporation or trust is typically formed, or an existing entity may be used or merged.
What is an UPREIT Structure?
An Umbrella Partnership Real Estate Investment Trust, or UPREIT, is a structure that publicly traded equity REITs use to acquire properties in a tax-efficient manner. The public REIT is the sole general partner of the operating partnership, holding the majority of limited partnership interests. The REIT generally consolidates the operating partnership in its financial statements.
Here’s how an UPREIT works:
- Formation: The REIT forms an operating partnership, which holds the real estate assets. Property owners transfer their properties to the operating partnership in exchange for operating partnership units instead of cash.
- Tax Deferral: This exchange is generally tax-deferred under Section 721 of the Internal Revenue Code, meaning property owners can defer capital gains taxes.
- Operating Partnership Units: Operating partnership units are economically equivalent to REIT shares but do not carry voting rights. They can be redeemed for REIT shares or cash, providing flexibility and liquidity to property owners.
- Benefits: The UPREIT structure allows property owners to diversify their holdings, gain liquidity and defer taxes.
- Management: The REIT acts as the general partner of the operating partnership, managing the properties and overseeing operations. The REIT typically holds a significant interest in the operating partnership, ensuring alignment between the REIT and property contributors.
The UPREIT structure is particularly beneficial for property owners looking to defer taxes while gaining access to the liquidity and diversification offered by publicly traded REITs. Benefits include:
- Tax Deferral: Property owners can transfer their properties to the UPREIT in exchange for operating partnership units on a tax-deferred basis, avoiding immediate capital gains taxes.
- Liquidity: Operating partnership units can be redeemed for REIT shares or cash, providing property owners with greater liquidity and flexibility.
- Diversification: By exchanging properties for operating partnership units, owners gain access to a diversified portfolio of real estate assets managed by the REIT.
- Consistent Income: Operating partnership units entitle holders to distributions equivalent to REIT dividends, offering a reliable income stream.
- Simplified Management: The REIT takes over property management responsibilities, reducing the hassle for property owners.
- Estate Planning: UPREITs can simplify estate planning by converting real estate holdings into more manageable and liquid assets.
These benefits make the UPREIT structure an attractive option for property owners looking to defer taxes, gain liquidity and diversify their investments.
Tax protection agreements enable contributors to negotiate "lock-out" periods to prevent taxable dispositions of contributed properties within an agreed period. Terms vary based on market conditions.
What are the Tax and Business Issues to Consider in a REIT Roll-Up Transaction?
There are numerous tax and business issues to consider in a REIT roll-up transaction. Below is a summary of what to discuss with your advisers prior to conducting this type of transaction.
Tax Issues
- Phantom Income from Debt Shift: Contributing partners often have negative tax capital accounts due to large depreciation deductions resulting in low-basis properties. Recourse/qualified nonrecourse debt allocations prevent negative capital accounts from being currently taxable. If a partner with a negative capital account does not have enough debt allocation, then it could create taxable income (phantom income). REITs may commit to maintaining sufficient debt to cover these accounts and prevent gain recognition.
- Carryover of Tax Basis: Properties contributed to the operating partnership carry over their tax basis, affecting depreciation and gain allocations. The method of allocating tax depreciation affects the REIT’s taxable income and distribution requirements.
- Valuation at Contribution Date: Accurate valuation of assets at the contribution date is crucial for tax reporting.
- Tracking of Section 704(c) Built-In Gain: Built-in gain refers to the unrealized appreciation in the value of an asset at the time it is contributed to a partnership. It is calculated as the difference between the asset’s fair market value (FMV) and its adjusted tax basis. Proper tracking of built-in gains under Sec. 704(c) to prevent shifting of tax items among partners is extremely important. When dealing with multiple built-in gain layers in partnerships, several complexities arise. Each layer must be tracked and allocated correctly among partners. In tiered partnership structures, built-in gain layers must be maintained across different partnership levels, adding complexity to the allocation process.
- Tracking Sec. 704(b) Book Capital: Book capital accounts are maintained under Sec. 704(b) to reflect partners’ economic interests in the partnership and ensure substantial economic effect.
- Impact on State and City Tax Filings: Contributing properties to a diversified portfolio can create additional state and local filings for the contributing member.
- Interest Limitations: A property owner that wasn’t subject to interest limitations under Sec. 163(j) could lose their small business status due to the larger combined portfolio or the syndicate rule. This may result in the loss of a current interest expense deduction.
- Simplification: While consolidating returns might appear to simplify filing, the first-year setup can be complex and the requirement to track built-in gain and Sec. 704(b) capital accounts results in a more complex tax filing.
Business Issues
- Bank/Tenant Approvals: Secure necessary bank and or tenant approvals for the roll-up and address any regulatory delays.
- Disagreement of Values: Resolve any disagreements on property valuations among stakeholders.
- Selling Less Desired Properties: There is an opportunity to sell less desired properties as part of the portfolio.
- Estate Planning and Wealth Transfer: Consider enhancing estate planning and wealth transfer strategies.
- Transition to UPREIT Structure: The roll-up facilitates easier transition to a future UPREIT structure.
- Sharing in New Investments: After the rollup, partners need to feel comfortable with the fact that they will own all future investments. They will not be able to pick and choose the investments they want to participate in as they did prior to the rollup.
- Revaluation for New Members: Revaluate assets when bringing in new members, applying Sec. 704(b) book-up to FMV.
- Up-Front Costs: Consider the expensive up-front costs required to implement the roll-up.
What is a DownREIT Structure?
If a REIT does not use the UPREIT structure, it can adopt the DownREIT structure to acquire properties on a tax-deferred basis. In this structure, the property owner contributes assets to a partnership, and the REIT contributes some of its properties. The property owner receives units with distribution and redemption rights similar to REIT stock.
The primary advantage of a DownREIT is the ability to defer taxes on the sale of appreciated real estate. This is achieved by exchanging property for operating partnership units rather than selling the property outright. Careful structuring is required to ensure the transaction is not considered a taxable event under IRS disguised sale rules.
Similar to UPREITs, DownREITs offer flexibility for both REITs and property owners, allowing property owners to transition their holdings into a diversified portfolio without triggering immediate tax liabilities. Qualifying as a REIT provides tax benefits, such as deductions for dividends paid to shareholders, but comes with restrictions on income sources, assets, distributions and organization. Failure to qualify can result in corporate income taxes and penalties.
REIT status and potential tax exposures are critical for financial statements, tax provisions, disclosures and internal controls. Proper planning and documentation are essential for compliance and avoiding disqualification.
Under the One Big Beautiful Bill Act (OBBBA), taxpayers may be eligible for a 20% deduction under Sec. 199A on REIT dividends, reported on Form 1099-DIV.
Publicly Traded Partnership (PTP) Classification: Redemption rights might cause operating partnership units to be treated as actively traded, potentially classifying the operating partnership as a corporation unless it meets the 90% income test. If classified as a corporation, the operating partnership’s income would be subject to corporate tax, and the REIT would fail income and asset tests.
Maximizing Investor Returns and Ensuring Regulatory Compliance
When considering the roll-up of your current entities into a new operating partnership, it is essential to evaluate both the overall goals and the specific issues that may arise. The primary objectives often include increasing the portfolio's value, accessing additional capital, unifying governance and facilitating estate planning. However, this process involves navigating complex tax implications, such as managing phantom income, tracking built-in gains, and ensuring compliance with state and city tax filings.
From a business perspective, securing bank approvals, resolving valuation disagreements and managing the costs of implementation are critical. Additionally, the potential for a smoother transition to a REIT structure and the benefits of unified governance and diversified investments can provide significant long-term advantages.
Careful planning, professional guidance and thorough consideration of both tax and business issues will be key to successfully implementing the roll-up and achieving your strategic goals.
Contact Asha Shettigar, Dave Sobochan or a member of your service team to discuss this topic further.
In this blog Cohen & Co is not rendering legal, accounting, investment, tax or other professional advice. Rather, the information contained in this blog is for general informational purposes only. Any decisions or actions based on the general information contained in this blog should be made or taken only after a detailed review of the specific facts, circumstances and current law with your professional advisers.