The world of real estate taxation is characterized by a complex array of tax rules that range from relatively straightforward to highly complex. Today, we will take a moment to delve into the intricacies of UPREIT transactions. If you are only looking for the tax reporting implications of an UPREIT transaction, skip to the last section.
Most tax professionals have clients who own and operate rental properties. Many of these clients either hold their rentals until they die or decide to sell them along the way to recover some cash, which they invest into other asset categories (because real estate isn’t for everyone). However, when a client comes to you to say they intend to sell their rental to purchase another and want to know the tax impact, this is a great time to discuss the §1031 exchange.
IRC §1031 exchanges allow taxpayers to sell their rental and use the proceeds to reinvest in another like-kind asset. Since 2018, taxpayers may only apply §1031 exchange to business or investment use real property. So, trading one piece of property for another. As this article is focused on DSTs and UPREITS, we will assume a basic understanding of the principles behind 1031 exchanges; if you’re looking to increase your knowledge of 1031s, we offer a 2-hour webinar on this topic.
If a taxpayer is looking to trade their property for a larger one, they may not have the means to do so on their own, so they may desire to acquire a new piece of property with other investors. Normally, when taxpayers invest in an activity with numerous investors, the activity is structured as a partnership or corporation. Unfortunately, if a taxpayer desires to exchange out of their rental property and into a partnership that owns a larger rental with other investors, this will not be considered a valid exchange. The taxpayer, for tax purposes, will be treated as though they acquired a partnership interest as the replacement property, which is not business or investment use real property and therefore will not qualify for §1031 treatment.
Delaware Statutory Trusts (DSTs)
A solution to this problem was created towards the end of the 20th century and was blessed by the IRS in Revenue Ruling 2004-86. The revenue ruling takes a fascinating approach to applying the “Check-the-Box” regulations for entity tax classifications to Delaware Statutory Trusts (DSTs). The basic premise behind the DST is that the goal for tax purposes is to have the entity treated as an investment trust, which is disregarded for federal tax purposes.
By being treated as a disregarded entity for federal tax purposes, the DST beneficiaries are considered to own the underlying assets of the trust. This means that when a taxpayer purchases a beneficial interest in the trust, what they are acquiring for tax purposes is the underlying real estate. While DSTs have numerous use cases, they have become an increasingly popular vehicle for real estate investments. The structure allows a large number of real estate investors to come together to purchase a large piece of real estate.
While DST providers often charge a hefty upfront fee for the privilege of investing in their trust and allowing for gain deferral for the investors, these investment vehicles provide benefits that the taxpayer may not otherwise be able to accomplish on their own. For example, owning a large piece of property with many available units substantially reduces the risks of vacancy. It also allows taxpayers to diversify against their geographic market risk and expand into different classes of real estate.
For the DST to be classified as an investment trust and disregarded entity for federal tax purposes, the trustee of the trust must not manage the day-to-day activities related to the rental property. It must be treated as an investment activity, not as a trade or business (which is why rentals held through a DST are not eligible for the Qualified Business Income deduction). The trustee of the DST will enter into a triple-net lease with a master tenant, who will then sublet the property to tenants who will actually utilize the property.
The problem with this structure is the lack of liquidity for the investor. Many financial advisors are aware of this issue and will push their clients to invest in multiple DSTs with different expected holding periods or maturity dates to provide their clients with liquidity. When the DST matures, the underlying asset is sold, and the beneficiaries receive their share of the proceeds. If a qualified exchange intermediary holds the proceeds, they engage in another §1031 exchange into a different DST or any other business or investment that utilizes real estate.
While having a diverse set of holding periods may allow for differing liquidity events, at no point in this process has the taxpayer converted an illiquid investment to one that is liquid and can be sold on the market at the taxpayer’s whim. Enter the UPREIT transaction.
UPREIT
In an Umbrella Partnership Real Estate Investment Trust (UPREIT) transaction, the DST contributes its underlying real estate to a partnership in exchange for limited partnership units. A Real Estate Investment Trust (REIT), which is classified as a corporation for federal tax purposes, contributes cash into the same partnership in exchange for general partner ownership units. The UPREIT name comes from the “Umbrella Partnership” nature of the transaction. The taxpayers who were beneficiaries of the DST receive their limited partnership units in the partnership in exchange for the contributed real estate in an IRC §721 transfer.
IRC §721 states that contributions of property to a partnership are generally tax-free. The taxpayer’s basis in the partnership interest is equal to the basis in the property contributed. The taxpayer will have to look to their adjusted basis in the underlying property to determine their basis in the UPREIT partnership units.
When the taxpayer desires to liquidate some of their partnership interest to generate cash, they may offer their limited partnership units to the REIT partner in exchange for shares of the REIT. When a taxpayer trades one piece of property for another, the transaction is generally considered a sale for federal tax purposes, which in this case is not eligible for §1031 exchange treatment (because the interests exchanged are not in business or investment use real estate).
The reporting of this type of transaction may appear to the taxpayer in many different ways. If the DST is held within a brokerage account, the broker may issue a 1099-B to the taxpayer, but it is unlikely to contain the taxpayer’s basis in their limited partnership units. Additionally, when the exchange of limited partnership units with REIT shares occurs, the taxpayer will be required to recognize §1245 recapture or any unrecaptured §1250 gain.
Note, at this time, while the taxpayer now holds REIT shares, they do not actually have any cash in hand to pay tax on the gain from the exchange of limited partnership units and REIT shares. The taxpayer’s basis in the REIT shares will be equal to the FMV on the date of such exchange, which means the REIT shares can be sold immediately on the open market to obtain cash.
Tax Reporting
Taxpayers and their advisors should carefully review the mechanics of a DST offering UPREIT functionality to determine any restrictions or timelines. While these structures are often pitched to offer liquidity to DST investors, the ability for the taxpayer to convert their partnership units for liquid REIT shares whenever they wish may vary.
For tax professionals attempting to understand the reporting requirements for this type of transaction, several key considerations must be taken into account. Until the DST contributes the underlying property to the UPREIT, the taxpayer will continue to report the rental activity on Schedule E (or Form 8825, in the case of an S corporation or Partnership). Once the property is contributed to the UPREIT, reporting on Schedule E (or Form 8825) will stop, and the taxpayer will begin to receive a K-1 from the UPREIT showing their share of the net rental income or loss.
As UPREIT partnership units are converted to REIT shares, the taxpayer will continue to receive a K-1 from the UPREIT until all of their partnership units have been converted. The REIT shares will then pass income out to the taxpayer as distributions are made (per Subchapter M of the IRC). Any sales of the REIT shares will be reported on Form 1099-B with basis equal to the FMV on the date they received the REIT shares.
Key Takeaways
For taxpayers looking to protect equity through tax-deferred exchanges, but also want to have the freedom to get cash whenever they need, DST to UPREIT transactions are a great option. Preparers working with these clients must be familiar with the peculiarities of the tax treatment to ensure proper reporting.