Why not diversify your assets while holding on to your profits by deferring taxes on the sale of your property?
This is but one potential advantage of UpREITs and DownREITs, largely underutilized instruments that can offer an additional means of deferring the capital gains taxes incurred from an asset transfer. In that regard, they are similar to 1031 exchanges, but given the aim that the current government has set for like-kind exchanges, investors should be aware of Up and DownREITs. Let’s examine each in greater detail.
A partnership that is still the owner of the real estate is below the REIT in an UpREIT (the “up” stands for Umbrella Partnership). As a result, the REIT does not really have title to the properties; rather, it only owns a stake in the underlying partnership. In contrast, a DownREIT will buy some properties outright and have a stake in a lower-tier partnership that controls the assets directly.
For the purposes of this discussion, let’s concentrate on UpREITs, even if most of what we’ll discuss also applies to DownREITs. Such a transfer of assets is not regarded as a taxable event under existing tax laws. Naturally, this changes if and when the partner transforms their portion of the assets they brought to the table into REIT equity shares. The gain must then be acknowledged. This implies that the investor has the option of timing in addition to the tax deferment. Naturally, this assumes that the REIT in question is a publicly traded REIT.
However, both have significantly greater transaction charges, and the closing is more difficult. Also, keep in mind that REIT equities are simply that—stocks—and not necessarily real estate. Remember that they closely track the S&P 500 as equities rather than more traditional real estate performance indicators such as interest rates.
But let’s get back to the advantages, one of which is asset diversification. For instance, all of your risk is present if you own just one piece of real estate. You effectively diversify that risk over all the properties in the portfolio, including yours, by donating that property to the REIT and getting operating partnership (OP) units in the REIT. This is, unsurprisingly, a significant draw for new participants.
Liquidity is another factor to take into account when choosing UpREITs over 1031s or conventional deals. A standard transaction may take up to 90 days to monetize, if you’re lucky. In contrast, it may just take a few days or weeks to convert OP units and sell the resulting shares.
Three other benefits must also be taken into account. Freedom from managerial obligations comes first. The success of the REIT is predicated in large part on the staff’s ability to effectively and efficiently manage an asset. REITs come with staff to handle those tasks.
Predictability and simplification come next . The owner of an OP unit can count on routinely occurring cash distributions in sums comparable to the cash flow from a single property. They are merely getting a check in exchange for their donation. Additionally, take into account the basic reporting obligations for REITs. No other sector, it can be said with confidence, does as good a job of informing its investors as the REIT sector does.
In light of the risks to the viability of 1031s and the current state of the economy, investors seeking a relatively safe haven vehicle should pay more attention to the benefits of Up and Down REITs.
