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UPREITs, Down-REITs And Other REIT Vehicles: Should You Go Along For The Ride?

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Since 1990, real estate investment trusts ("REITs") have been the primary new vehicle through which investors have chosen to own real estate. Market capitalization has expanded from $5.5 billion in 1990 to nearly $140 billion as of June 30, 1998. With approximately 150 of the 300 REITs in existence now listed on the New York Stock Exchange and nearly 50 real estate mutual funds investing in REITs, the financial markets have become keenly interested in the REIT industry. REITs now represent 5% of the total market value of commercial real estate in the United States.

The strong trend towards real estate securitization and the tax-advantaged status of REIT vehicles has fostered new transaction and entity structures. UPREITs, Down-REITs, stapled and paper clipped REITs and their corporate analogs have become the real estate buzzwords of the Nineties. Understanding the business and tax considerations surrounding REITs, UPREITs, Down-REITs and their related structures is now an essential for a real estate owner or professional.


While originally created as a passive investment vehicle for real estate investors to obtain the same benefits that mutual funds provide for investors in securities, REITs are no longer passive vehicles. Prior to the Tax Reform Act of 1986 ("1986 TRA"), REITs were restricted as to the management services they could provide and were viewed as essentially fixed income investments. Accordingly, REITs were valued primarily by reference to their distributions. The 1986 TRA, for the first time, generally allowed REITs to directly provide services to tenants rather than to require an independent contractor to provide such services. As a result, REITs can presently provide a wide array of services without violating tax rules. Having taken advantage of the 1986 TRA changes, today REITs are valued in the investment world much like other active businesses.

The basic requirements for REIT status generally relate to the organization, income, and assets of the entity selected. In order to qualify as a REIT the entity must, among other things:

  • be organized as a corporation, trust or association and be managed by one or more trustees or directors ('856(a)(1));1
  • have fully transferable shares or certificates of beneficial interest ('856(a)(2));
  • be owned by 100 or more shareholders ('856(a)(5));
  • not be a closely held corporation ('856(a) and '542(a)(2); see also '856(h));
  • derive at least 75% of its gross income from rents from real property, interest on loans secured by real property, gains from sale or other distribution of real property or real estate assets, abatements and refunds of real property taxes, and income and gain derived from foreclosure property ('856(c)(3));
  • derive no more than 30% of its gross income from the sale of real property held less than 4 years (excluding foreclosure property and involuntary sales) or securities held less than 12 months ('856(c)(4));
  • distribute at least 95% of its taxable income, excluding net capital gains ('856(c)(2));
  • invest at least 75% of the value of its total assets in real estate or real estate mortgages, cash and cash items, including receivables, and government securities ('856(c)(5)(A));
  • invest no more than 25% of the value of its total assets in securities, other than securities includible under the 75% test ('856(c)(5)(B));
  • invest no more than 5% of the value of its total assets in the securities of any one issuer, other than securities includible under the 75% test ('856(c)(5)(B)); and
  • own no more than 10% of the outstanding voting securities of any one issuer, other than securities includible under the 75% test ('856(c)(5)(B)).

A REIT avoids double taxation through its status as a pass through entity. However, a REIT will be subject to tax to the extent of undistributed taxable income so it is typically viewed as being more akin to a taxable corporation that can reduce its tax through a dividends paid deduction.

UPREITs and Down-REITs

The UPREIT structure was created to avoid recognition of taxable income on the transfer of appreciated property to a REIT.2 UPREITs have accounted for nearly two?thirds of all newly formed REITs since 1992. Today, over half of the largest REITs are organized as UPREITs.

In a typical UPREIT structure, one or more individuals and/or partnerships owning real estate contribute their holdings to an "umbrella partnership" in exchange for limited partnership units, sometimes called operating partnership units. Contemporaneously, a REIT ' is formed and issues shares to the public. The REIT then contributes the proceeds received from the REIT shareholders to the umbrella partnership in exchange for a general partnership interest. The proceeds are used to reduce debt or acquire additional property or used for any other REIT purposes. The limited partners also receive rights to "put" their partnership interest to the umbrella partnership or to the REIT in exchange for cash or REIT shares. A diagram of a typical UPREIT structure is set forth in the figure below.


The Down-REIT structure was created as an analog to UPREITs for those REITs which did not have or desire to form an umbrella partnership and also to provide additional structuring flexibility for existing REITs. UPREITs have used Down-REITs to provide additional structuring flexibility as well.

In a typical Down-REIT structure, a property owner becomes a partner in a limited partnership with the REIT (if no UPREIT exists), the umbrella partnership of an UPREIT, or a wholly-owned subsidiary of the REIT or UPREIT, as the case may be. The newly formed limited partnership owns and operates the property and possibly other income producing property contributed by the other partner (i.e., the REIT, UPREIT or wholly-owned subsidiary thereof). A diagram of a typical DownREIT structure is set forth in the figure below.


Competitive Structures

If the sole motivation of the owner is to avoid the recognition of taxable income, other transactions and structures may also be available to achieve that goal. These transactions and structures are, in some cases, viable alternatives to UPREIT or Down-REIT structures.

Under the 1986 TRA, the like kind exchange rules were modified to provide more secure but more rigid guidelines for so-called non-simultaneous exchanges. To achieve a tax deferral under the 1986 TRA rules, a replacement property must be identified within 45 days following the disposition of the property, the proceeds must be segregated and maintained with a "qualified intermediary" prior to reinvestment and the proceeds must be reinvested within 180 days of the sale. Up to three reinvestments may be made. Partially as a result of the strictures of these rules, there are today "national" qualified intermediaries who provide "exchange" services to a selling owner. These qualified intermediaries often work with a developer or owner who has an ongoing relationship with one or more REITs. When a newly acquired or newly developed property is stabilized, the developer or owner will sell the real estate to a REIT, beginning a like kind exchange. To complete the transaction, the developer or owner will acquire another property that has been owned separately by a special purpose entity that is neither owned nor controlled by the developer or owner. The special purpose entity, on behalf of the developer or owner, will typically acquire existing property, purchase land and develop new properties to the developer or owner's specifications using the developer or owner's contractors and developers. This approach allows the developer or owner to warehouse or stockpile potential replacement properties that the developer or owner can later acquire from the special purpose entity as needed to meet the timing requirements of like kind exchanges. The beginning event for the like kind exchange is triggered by the developer's or owner's sale of an existing property. If the replacement properties are warehoused property, the developer or owner has created its own pool of replacement properties. There are a number of national qualified intermediaries who provide services to developers or owners with respect to the identification and selection of replacement properties. The use of the special purpose entity warehousing approach is supported by substantial precedent.

Another form of competitive transaction which has been utilized involves the issuance of "stepped down preferred stock". In one form of stepped down preferred stock transaction, a corporation creates a REIT that sells a special class of preferred stock to a tax-exempt or foreign person and common stock to the corporation creating the REIT. The REIT then lends the funds raised to the corporation that created it. The preferred stock receives a very high dividend until the investor's purchase price is effectively amortized, then the dividend rates steps down to the very low rate and the common shares start receiving dividends. In this structure, the corporation that created the REIT receives interest deductions and the tax exempt or foreign investor has non-taxable dividend income. In several cases, the Internal Revenue Service has issued notices that it would disregard the REIT and treat the transaction as a loan to the corporation owning the common stock under '7701(1). The service clearly views the issuance of such securities as abusive.3 Nonetheless, the use of REITs in "creative" tax planning will likely continue.

In addition to like kind exchanges or exotic forms of transactions, many varieties of co- investments with other real estate funds are being undertaken and may well provide an attractive combination of control and liquidity for the real estate owner or developer through buy-sell options, puts and other more traditional partnership features. Because of the number and size of the funds in the marketplace, transactions with these funds may be entirely competitive with transactions involving UPREITs or Down-REITs.

Stapled (Paired-share) and Paperclipped REITs

In a stapled stock structure, the shares of a REIT in an operating company (organized as a C corporation) that operates an active business closely integrated with the real estate owned by the REIT are stapled together so that neither can be disposed of without the other. Existing stapled stock REITs were grandfathered in 1984, and until recently, traded at a higher multiple for their shares than for the shares of unpaired REITs.

The principal advantage of a stapled stock structure is that as a result of the identity of shareholder interests, the shareholders are indifferent to the allocation of income between the REIT and the operating company, except for the tax consequences. To the extent income is attributable to the non-taxable stapled REIT, liability is reduced. In a typical stapled stock structure, the property will be owned by the REIT and leased to the operating company. The deduction of rent by the operating company will reduce or eliminate taxes payable by the operating company. The stapled stock structure has been utilized until recently to acquire operating companies in specialized management businesses. To ensure the continuance of the stapled stock structure, cross rights of first right of refusal for ownership and lease are provided (i.e., properties acquired by the REIT will be leased to the operating company and property acquisition opportunities obtained by the operating company will be made available to the REIT). However, recent legislation (the "1998 legislation") has now frozen the grandfathered status of stapled REITs, thus stimulating great interest in alternative structures.

In order to obtain some of the perceived benefits of the stapled stock arrangements, some REITs have created what has been referred to as "paperclipped" structures as an alternative to the prohibited stapled stock arrangements. In a paperclipped structure, shareholders hold, initially prorata, stock in both a REIT and an operating company. For shareholders who hold stock in each company, the structure provides a single tax return on the real estate assets owned by the REIT and leased to the operating company. At the same time, the separate operating company provides these shareholders with an after tax return from a business that cannot be engaged in by the REIT. Shareholders will be motivated to hold or dispose of the shares as a "pair" although the shareholders would have the option to trade the stock separately. The range of businesses in which REITs cannot engage, and therefore could make use of the paperclipped structure, includes parking operations, hotels, and health businesses. The paperclipped structure is designed to avoid the application of '269 which would cause the REIT and the paperclipped operating company to be treated as a single entity and thereby disqualify the REIT because of the large amount of non-qualifying gross income which would be earned by the paperclipped operating company.

In a typical paperclipped structure, the REIT will purchase the facilities of the operating business and form a subsidiary into which business operations are contributed. The shares of the subsidiary are then spun off to the REIT shareholders. The shares of the two entities are freely tradable and therefore identity of ownership is not assured as it would be in the stapled stock structure. However, strong alignment is maintained through the use of cross first rights of refusal (as described above) and by the installation of the same management in both companies. In addition, the REIT may maintain up to a 50% ownership interest in the operating company although it cannot have more than 10% of the voting power in the company.

The advantages of the paperclipped structure are similar to those of the stapled stock structure, at least initially. In both cases, the REIT and the operating company share managements and pursue the same investment and operating objectives. However, since, in the case of a paperclipped structure, the shares of the REIT and operating company do not trade together, the shareholder bases will likely diverge over time. As a result, several of the existing stapled REIT are considering an alternative which avoids the strictures of '269 and the 1998 legislation.

This alternative, which has been dubbed "semi-stapling", envisions a scenario under which two classes of stock would be issued, one of which would represent ownership of 1000%, of a corporation and less than 50% of the REIT. The balance of the REIT ownership would be represented by the second class of stock. A semi-stapled structure would preserve the advantages of a stapled stock arrangement in that it would minimize conflicts between the REIT and the operating company.

A comparison of the attributes of a typical UPREIT and Down-REIT structureillustrates some striking differences as to the business and tax considerations.

Rate of Return to Contributing OwnerIdentical in amount to those received by REIT shareholders
First priority return equal to the return of the former owner at the time of contribution or a return that mimics REIT shareholder return
DiversificationDiverse larger pool of assets to generate cash flowSingle asset or non-diverse smaller pool of assets
Put OptionUnits exchanged on a one for one basis with REIT sharesNegotiated exchange ratios
Sale of Contributed PropertyTriggers taxable gain with more cash to other UPREIT partners but contributing owner will have remaining investmentTriggers taxable gain with more cash going to contributing owner but no remaining investment
Tax DifferencesDisguised sale rules are not likely to apply

Anti-abuse rules specifically sanction UPREITs
Disguised sale rules may apply

Anti-abuse rules may apply


The favored tax status, which Congress has created for REITs, has provided an important source of liquidity for real estate developers and owners. However, the question whether a transaction with a REIT, UPREIT, Down-REIT or other REIT vehicle is appropriate in a particular circumstance is driven not only by the myriad of tax considerations which may apply but also by a host of fundamental business, considerations relating to the entity with which the developer or owner proposes to do business. Understanding a REIT's strengths and weaknesses, including the quality and experience of existing management and the operating philosophy and investment disciplines maintained by management, is as important to the discussion whether or not to proceed with a particular transaction as the economic and tax considerations.

The most significant economic advantages for both the REIT and the transferring owner will be achieved when the operating philosophy and investment disciplines of the REIT match those of the owner. Only then should the owner go along for the ride.


1 All section references are to the Internal Revenue Code as amended, and the regulations thereunder, unless otherwise indicated.

2 I.R.C.'351(a) provides that no gain or loss is recognized if property is transferred to a corporation provided that after the transfer the transferring persons are in control of the corporation. However, '35 1 (a) does not apply to transfers to an "investment company". If the transferee is a REIT, the transfer is deemed to be to an investment company. By analogy, '72 1 (b) denies tax-free treatment to contributions to a partnership if the partnership is deemed to be an investment company. However, the umbrella partnership would not be considered an investment company unless 80% or more of its assets were invested in securities or it elected REIT status.

3 See Michael S. Powlen, Practicing Law Institute, Tax Law and Practice "Corporate Tax Shelters or Plus CA Change, Plus C'est La Meme Chose" (October-November 1997)

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