This article originally appeared in the October 1998 issue of Los Angeles Lawyer

TRANSFERS OF REAL PROPERTY TO UPREITS & DOWNREITS:
A PRACTICAL OVERVIEW

by Tony Salandra
 
Akin, Gump, Strauss, Hauer & Feld, L.L.P.
Century Tower Plaza
2029 Century Park East
Suite 4150
Los Angeles, California 90067

Real Estate Investment Trusts ("REITs")/1 have been one major force fueling the resurgence of property values for most of the current decade, a period during which the publicly traded REIT industry's aggregate market capitalization has also risen dramatically./2 Much of this growth is attributable to the industry's ability to attract potential property sellers through the use of tax-deferred disposition mechanisms in the form of UPREITs and DOWNREITs, which have grown in prevalence since the first UPREITs appeared in the early 1990s./3

To illustrate the attraction, the following prototype client ("client") may want to transfer real property ("Property") to an UPREIT or DOWNREIT. He has held his Property for years (either individually or through a partnership) and now has a substantial built-in gain. He wants to improve his investment liquidity, diversification and financeability, while maintaining the ability to collect tax-sheltered cash flow to some extent and continuing to defer tax on his gain for an extended period. In addition, he now desires an absence of managerial responsibility, a reasonably guaranteed return on investment and possibly the chance to transfer the investment at death without ever paying income tax on the built-in gains, all the while continuing to participate in any further appreciation in the real estate market. The UPREIT or DOWNREIT structure is uniquely designed to satisfy, in large part, each of these goals.

From the REIT's perspective, the transaction is an opportunity to acquire control of the Property now, by essentially promising to pay for it with REIT stock in the future, thus immediately expanding the REIT's holdings without currently depleting its cash resources, issuing additional stock or incurring debt.

BASIC STRUCTURE

The "UP" in the term UPREIT stands for "Umbrella Partnership," which is an operating partnership or limited liability company ("OP") managed by the REIT (as general partner or managing member) in which essentially all of the REIT's real estate is held. In a "DOWNREIT" (the term simply distinguishes it from an UPREIT) the OP (which is often formed to acquire one particular Property) holds only a part of the REIT's property portfolio, with its other properties owned directly by the REIT and/or by other DOWNREIT OPs managed by the REIT. In both UPREITs and DOWNREITs, the client contributes the Property to the OP (or, if the Property is already held in a partnership, the client's historical partnership interest could instead be transferred to the OP or the historical partnership could contribute the Property to the OP and then itself liquidate)./4 In exchange, the client receives limited partnership (or LLC) interests in the OP ("OP Units"), presumably tax-free under Section 721(a)./5 thus affording him the opportunity for continued deferral of built-in gain (and possibly even total avoidance of this gain if the OP Units are held until death)./6 So long as the client holds OP Units, he will receive periodic (usually quarterly) OP operating cash distributions equivalent to the dividend rate paid to the REIT's shareholders. This would generally be expected to deliver a reasonably predictable cash flow stream over a long term, which may even be tax-sheltered by OP loss/deduction allocations to the client to the extent permitted by applicable tax principles.

With the stage having been set for long-term gain deferral and reasonably dependable cash flow, the client's attention may turn to available liquidation strategies. The key feature in this regard is that the OP Units are exchangeable (at the client's election) for REIT shares, generally in a one-for-one exchange ratio, usually after a specified, negotiated waiting period (the "lockout period"). If and when the client exercises this exchange right, the REIT must pay the client the value of the OP Units (i.e., the value of a corresponding number of REIT shares at that time) either in cash or in REIT shares (the REIT generally decides which form of consideration to use). This effectively gives the client the investment diversification, liquidity and appreciation potential inherent in the stock of the REIT. Indeed, because the OP Units carry exchange rights, potential lenders, particularly those accustomed to making margin loans on publicly traded stock, are often quite willing to lend against OP Units. This gives the client more liquidity (without immediate tax consequences) than he enjoyed while holding the (perhaps already fully encumbered) Property.

The exchange, when ultimately consummated, is generally treated as a taxable sale or exchange by the client at the time the exchange consideration is received, whether in REIT shares or cash./7 Accordingly, the client will usually want to promptly sell any shares he so receives (to raise cash to pay tax on his gain) and, therefore, the receipt of stock raises practical business and legal concerns including the presence of registration rights, the stock's daily trading volume, brokerage commission costs, bid/asked spreads and other matters affecting share pricing, liquidity and immediate transferability. As a matter of form, the client's exchange rights may, instead, be styled as a right to require the OP to "redeem" OP Units, once again with the REIT deciding whether to use cash or REIT shares./8 The client may choose to exchange/redeem all or only a part of the OP Units, thus giving him flexibility as to when and how many OP Units he wants to exchange.

THE REGULATIONS UPREIT EXAMPLE

A tax-free contribution of property to an UPREIT OP under Section 721(a) was approved in an Example ("the Example")/9 in the partnership "anti-abuse" regulations./10 In the Example, a newly-formed REIT contributes cash (raised in an initial public offering) to an UPREIT OP. Two existing partnerships contribute real estate to the OP in exchange for OP Units. They then distribute the OP Units to their partners and liquidate. The OP Unitholders (or "some" of them) may redeem their OP Units (after a 2-year lockout period) for cash or REIT stock, with the consideration to be equal to the value of the OP Units upon redemption. The Example concludes that the transaction is consistent with the intent of sub-chapter K, notwithstanding that the OP was formed to avoid the gain recognition which would have resulted under Sections 351(e) and 357(c) in a contribution directly to the REIT in exchange for REIT shares.

Despite the Example's apparent blessing of tax-free property contributions to OPs, the IRS could attempt to recharacterize any particular client's OP Units as the taxable receipt of a de facto interest in REIT shares. This might be a concern if the deal's overall economic terms make the exercise of exchange rights a foregone conclusion, since the Example makes the factual point that the taxpayer is "not compelled, as a legal or practical matter, to exercise [his] exchange rights at any time."/11 Similarly, the recharacterization issue might be worrisome if the OP does not substantively reflect a bona fide partnership arrangement with overall attributes sufficiently distinctive from those of the REIT's actual shareholders. In this regard it may be noteworthy that in the Example, the redemption/exchange right is at the fair market value of the OP Units at redemption. In practice, most exchange rights are determined principally by a ratio (usually one-to-one) of OP Units to REIT shares. Accordingly, if the client has no real ability to share in the Property's economics beyond the receipt of dividend-equivalent distributions, the IRS might be more inclined to view his OP Units as practically indistinguishable from REIT shares. Accordingly, the basic requirements of the "anti-abuse" regulations should not be disregarded.

SOME TYPICAL CLIENT TAX CONCERNS

The contribution of the Property to the OP raises many of the same concerns present in non-REIT partnership contexts. For example, under Section 704(c): (i) the Property's pre-contribution built-in gain generally must ultimately be allocated to the client when recognized by the OP; and (ii) allocations of other OP tax items under Section 704(b) generally must take into account the disparity between the Property's adjusted basis and its agreed-upon "booked-up" value./12 In particular, Section 704(c) generally requires the lion's share of Property depreciation deductions (i.e., depreciation based on booked-up value) to go to the non-contributor partner(s). However, under the so-called "ceiling rule," the OP's annual tax deductions for depreciation would be based on the Property's lower historical tax basis. This may limit the depreciation deductions available to the REIT/13 and effectively increase the REIT's net income from the OP. Consequently, the REIT may need to make higher distributions to its shareholders under Section 857(a)(1), which generally requires that 95 percent of the REIT's income be so distributed. To solve this problem, the REIT may want to increase its share of the OP deductions by using either "curative" allocations/14 or "remedial" allocations./15 The client may want to resist these methods if he can (especially in a DOWNREIT if he is the sole property contributor) because they both may create additional taxable income to him without additional cash distributions.

Another concern is that the client's built-in gain may be immediately triggered upon contributing the Property to the OP, to the extent any reduction in his "share" of liabilities exceeds his adjusted tax basis under Sections 704 and 752./16 Similarly, gain could result later from a refinancing (e.g., due to a shift from nonrecourse debt to recourse debt, a lower principal amount, addition or removal of a guaranty, debt modification, or even regular principal amortization) or from a taxable disposition of the Property by the OP./17 The client's share of OP liabilities from time to time might typically include: (i) liabilities for which he is ultimately personally liable with no right of reimbursement from others (including as a result of personal guaranties with waivers of subrogation rights) and (ii) a portion of the OP's nonrecourse liabilities, pursuant to the usual three-tiered characterization system./18 In order to maintain tax deferral under (or despite) the above rules, the client may need to incur or maintain personal liability for OP debt by providing a personal guaranty. Such a guaranty might be carefully tailored to apply only upon certain specified events (e.g., a foreclosure or other sale of the Property below a specified price) and/or only to a specified portion of relevant debt (e.g., to the "first dollars" payable on the debt — sometimes referred to as a "bottom-dollar guaranty"). If so, it should indicate whether regular principal amortization payments will reduce the client's "bottom dollar" obligation, since this may cause the guaranty amount (and possibly the tax deferral) to partially evaporate with each OP debt service payment. Creating a carefully tailored "bottom dollar guaranty" for particular debt is relatively straightforward in a single-property DOWNREIT. In an UPREIT, with its multiple partners, properties, liabilities and possibly guaranties and cross-collateralized blanket mortgages,/19 this may be a more difficult proposition./20

Other debt-related tax issues include whether the debt constitutes: (i) a "qualified" liability under the "disguised sale" rules in Section 707(a)(2) (since the absence of such qualification could potentially trigger tax) and (ii) "qualified nonrecourse financing" under the at risk rules of Section 465 (because this may be necessary to avoid current tax from at-risk recapture and/or to permit further loss allocations to the client).

For varying reasons, both REIT and client may want the OP to make a Section 754 election at some point. Accordingly, they should agree upon their relative rights to require (and/or revoke) such an election, which allows certain tax-beneficial adjustments to the basis of OP property upon transfers of OP Units and/or certain distributions to the OP's partners.

If the Property is already in a partnership, and that historical partnership contributes the Property to OP in exchange for OP Units and distributes them, the client might recognize some gain under Section 731(c), which applies to distributions of "marketable securities" (which may include OP Units)./21 If, instead, all of the partners of that historical partnership contribute their partnership interests to the OP, a termination of that partnership may occur under Section 708(b)(1)(B). Any OP itself could also be deemed so terminated upon the sale or exchange of OP Units (by exercise of exchange rights or otherwise) representing 50 percent or more of OP capital and profits interests within a period of 12 months. Such terminations can cause additional accounting, return filing, depreciation and other complications.

Finally, the contribution of a California Property to the OP would generally trigger higher property taxes./22 An existing partnership might possibly avoid this by keeping its Property and admitting the REIT as a partner, in effect allowing the existing partnership to serve as the OP. For this strategy to work, the other partners must maintain a sufficient interest to prevent a "change of ownership" under California Revenue and Taxation Code Section 64. Also any resulting property tax savings might be subsequently lost or reduced due to annual inflation adjustments,/23 "new construction"/24 or later changes of ownership, whether by a transfer of the Property itself, or by the transfer or exchange of the OP Units./25 While present, such tax savings would produce relatively higher OP cash flow which can be shared by agreement between the client and the REIT. This structure might also avoid documentary transfer taxes under Cal. Rev. & Tax. Code § 11911, et seq., sales tax, bulk transfer rules, due on sale clauses in mortgages and third party option/consent rights.

COMPARISON OF UPREITS AND DOWNREITS

In some situations, the client may have little choice but to use a DOWNREIT because no UPREIT structure may be available from the particular REIT interested in his Property. In others, one or both parties may prefer a DOWNREIT for its flexibility, relative simplicity and/or for other reasons described below./26 While there is no IRS authority expressly approving DOWNREITs, the basic tax principles in the UPREIT Example should be similarly applied to a DOWNREIT./27 However, some practical (and potentially tax-impacting) differences can arise because a DOWNREIT OP generally has a much smaller pool of assets against which the client might seek to enforce his rights to receive (i) periodic cash flow distributions, (ii) cash or REIT shares upon redemption of his OP Units and (iii) performance of other OP obligations. Accordingly, the client may wish to extract some direct contractual obligations from the REIT itself in order to have recourse to the REIT's overall net worth for these purposes./28 However, care must be taken that any such direct REIT obligations would not result in a reduction of the client's share of OP liabilities or a re-characterization of the transaction under the "anti-abuse" regulations or other form-versus-substance principles. Other approaches in this regard might include requiring the REIT to make substantial capital contributions and/or capital commitments to the DOWNREIT OP, either in cash or in other property (although, practical, business and legal limitations may impose an upper limit to this strategy) and/or including adjustments in the exchange formula to account for any missed distributions to the client.

From the REIT's viewpoint, because an UPREIT OP involves the REIT's entire property portfolio and numerous limited partners, the documentation must contain greater rights, restrictions, and protections in the REIT's favor, both to give it maximum flexibility to operate its business and to prevent any inadvertent termination of its REIT tax status. In contrast, DOWNREIT documents need only govern the client and a relatively small part of the REIT's overall portfolio and, thus, pose a less daunting set of concerns in this regard. Accordingly, UPREIT documents tend to be longer, more complex, pre-formed, more standardized, less "negotiable," and less flexible for the client (and to some extent, the REIT itself). This may comparatively limit the client's ability to negotiate special allocations, unique economic terms, exit strategies, client managerial approval rights or other protective provisions in the UPREIT context. Also, because a DOWNREIT is generally more custom-made, transaction costs for both parties may be higher, although the tax, economic and other benefits obtained from added flexibility and specificity should make this additional cost well worthwhile.

The UPREIT OP's multiple assets and partners may also produce a wider array of income, gain, loss, deduction, and credit items from the various properties, in contrast to a single-Property DOWNREIT OP, and, in addition to federal tax burdens, these matters may involve numerous state and local taxing jurisdictions carrying attendant multiple tax payment, reporting and filing obligations for the client. Also, in a single-property DOWNREIT OP the Section 704(c) "ceiling rule" is less likely to effectively limit the REIT's tax depreciation because the OP Property's depreciation deductions can all go to the REIT if need be; but they must be shared with numerous non-contributor partners in an UPREIT. Further, a DOWNREIT should reduce worries about the tax and business effect of later capital contributions raised in secondary stock offerings, which are common in the UPREIT context and which may trigger complicated tax, accounting and administrative consequences.

CONTRACTUAL PROTECTIONS

Since the REIT (as the OP's general partner) controls the operation, financing and disposition of the OP's Property, the client needs contractual protections against activities which would cause gain recognition prior to the time that he decides to voluntarily trigger gain by exercising exchange rights. For example, if the REIT were to replace, pay down, modify, cross-collateralize or guaranty OP debt, this could produce taxable gain./29 Debt cross-collateralization (or even mere cross-default) provisions could also increase the risk of "phantom" gain from a Property foreclosure. Accordingly, the REIT should agree to cause the OP to maintain Property-secured debt of a specified amount and type that is allocable to the client under the principles of Sections 704 and 752. If the debt is subject to cross-default provisions on other REIT/OP loans, then the REIT should agree to either cure any default or effectively replace the defaulted debt with similarly satisfactory debt. To verify compliance, the client might require advance copies of and input on OP tax returns. If the client needs to guaranty OP debt to maintain his tax deferral, the REIT should covenant that it will allow him to continuously maintain a guaranty for the agreed deferral period.

The REIT should also agree not to dispose of the contributed Property for the agreed tax deferral period, since this would generally trigger taxable gain to the client. Like-kind exchanges could be allowed, provided that they do not trigger client gain from "boot"/30 and the exchange property received is satisfactorily encumbered. The REIT might also accept a "best-efforts" obligation to replace the Property following any condemnation or destruction, again to preserve the client's tax deferral./31 Nonetheless, the client may want flexibility to transfer OP Units to others; and perhaps more importantly, the right to pledge them to obtain loans.

In a single-Property DOWNREIT OP, the client might also require that the OP be "bankruptcy remote" (i.e., a separate entity that would not be subject to substantive consolidation with the REIT in a bankruptcy). Toward this end, the OP might be required to maintain separate books and records, conduct business in its own name, maintain separate unconsolidated financial statements, pay salaries and expenses directly from its own funds, avoid cross-collateralized debt, observe the formalities of applicable partnership or LLC law and refrain from bankruptcy-triggering actions. This is intended to (i) lessen the risk of OP bankruptcy or a taxable foreclosure of OP Property and (ii) possibly allow the client to continue to look to the OP's Property to return his capital and profits, if the REIT falls on hard times. The REIT might also promise to fund any operating cash shortfalls at the DOWNREIT OP level. Such funding should be styled as additional capital contributions and not as payments under a "guaranty" (which could entitle the REIT to preferential payback under subrogation principles and also could possibly cause a taxable shift of OP liability sharing); and any return of these additional capital contributions should be junior in the OP's cash distribution scheme to avoid dilution of the client's dividend-equivalent operating distributions.

If the REIT or the OP defaults under these tax-related obligations, the REIT should indemnify the client from resulting acceleration of federal, state and local income tax liabilities. The indemnified tax liability might be stated in a fixed liquidated damages amount/32 or by way of a formula based on the time value of the lost tax deferral.

The REIT will want to reserve maximum flexibility to avoid recognizing income of types or in amounts greater than permitted by the 95 percent income test of Section 856(c)(2) and the 75 percent income test of Section 856(c)(3), including the ability to re-allocate income items to the client if necessary, particularly in UPREIT OPs (through which essentially all of the REIT's potential income would flow). These tests are critical to maintaining REIT status. Such income re-allocations could potentially work some "phantom" income hardship on the client. The client would also be required to covenant that neither he nor transferees of his Units will at any time own (directly or by attribution) REIT stock in excess of the levels permitted by the "closely-held" ownership limits of Section 856(a)(6);/33 once again this is critical to maintaining REIT status. The REIT may also want to specify its ability to withhold from payments and distributions to the client if required by Sections 1441, 1442, 1445 and 1446 or state tax laws. The REIT will also generally require typical real estate purchase agreement-type protections, including due diligence periods, client/seller representations and warranties about the Property, FIRPTA and tax clearance certificates, allocations of sales tax liabilities, any necessary consents of lenders or others, and reasonable prorations of items, such as rents, interest, security deposits, taxes, utilities and other adjustments before closing.

UPREITs and DOWNREITs can deliver a client tax deferral, real estate portfolio diversification, liquidity, relief from managerial responsibilities and the opportunity to continue to participate in the upside potential of his real estate investment. However, like any complex tax structure, the benefits can only be achieved and maintained by carefully planning the transaction. These potential client benefits, coupled with the ability of REIT industry participants to employ these vehicles to expand their holdings without raising additional funds, should insure that UPREITs and DOWNREITs will continue to be a prominent feature of the real estate market and in the workloads of real estate, tax and securities lawyers for the foreseeable future.

Tony Salandra is senior counsel in the real estate department of Akin, Gump, Strauss, Hauer & Feld, LLP in Los Angeles, where his practice emphasizes tax-sensitive real estate transactions and real estate investment products.

©1998. Tony Salandra. All rights reserved.