The terms UpREIT vs DownREIT describe the differences that exist in the corporate structure of REITs. The concept of UpREIT, which stands for “Umbrella Partnership Real Estate Investment Trusts,” was introduced in 1992. An UpREIT allows long-established REITs to pool all the real estate properties that they own under a new REIT structure without selling any of the properties to the REIT. It means that the new REIT does not directly own any properties.
At the same time, a DownREIT allows an investor to become a partner with a REIT by entering in a joint partnership agreement. Both structures permit investors to defer capital gains taxes on the sale of appreciated real estate properties.
UpREITs and DownREITs are types of corporate structures of REITs that allow investors to defer capital gains taxes on the sale of appreciated properties.
An UpREIT allows investors to contribute their real estate investment holdings to an umbrella partnership in exchange for limited partnership units.
A DownREIT allows investors to become partners in a partnership agreement with a REIT.
What is an UpREIT?
An UpREIT is an alternative to DownREIT, and it allows property owners to contribute to an umbrella partnership in exchange for limited operating hat units tare equal to the value of the contributed property. The investors are awarded put options, which can be converted into cash or REIT shares after an agreed period in the future.
The proceeds received can be used to acquire more real estate properties, pay up debts, or for other REIT-related purposes. All the management functions are downstreamed to the umbrella partnership, and the new REIT works as a holding company.
UpREITs can also be used as an estate planning tool, where investors can transfer their estates to their heirs tax-free. The heirs can postpone exercising the put option until after the owner’s death when the partnership units are broadened to the market value.
They can then exercise the put option without paying capital gains taxes on the appreciated value of the underlying real estate assets. Exercising the put option after the death of the property owner provides greater liquidity to pay estate taxes and prevent income tax on subsequent taxation.
What is a DownREIT?
A DownREIT is a relatively newer structure compared to an UpREIT. Unlike an UpREIT, where all activities of the REIT are performed at the partnership level, a DownREIT is a joint partnership between the property owner and the REIT. The DownREIT structure was created for property owners who do not intend to operate under an umbrella partnership, but instead, the owners become partners in the limited partnership with the REIT.
The new limited partnership can own and operate real estate properties. Some of the properties may be acquired directly or owned through limited partnerships with property owners who contributed properties to the partnership.
DownREITs are preferred by investors who want to avoid paying capital gains taxes on the sale of appreciated real estate property if they believe that the value of their properties will significantly exceed the value of the REIT-owned properties. The investment performance of the DownREIT depends on the owner’s property, and not the entire portfolio of the REIT. The investor owns a put option that can be converted into the REIT shares or cash, and the conversion value depends on the value of the property owner’s real estate investments at that particular time.
However, the structure of a DownREIT is rather complicated, and investors often hire the services of a tax expert to help them structure the investment appropriately. DownREITs tend to attract the attention of the Internal Revenue Service, and the federal tax agency may consider the transfer of property to the DownREIT as a taxable event, unless properly structured.
Comparing UpREIT vs DownREIT
1. Tax benefits
UpREITs tend to be more widely used by real estate investors due to their tax advantages and simplicity. If an investor’s goal is to defer capital gains taxes, an UpREIT is the best option since the transfer of appreciated property of the REIT does not create a taxable event.
DownREITs tend to adopt a complex operating structure. As a result, they may require the investor to spend extra on hiring a tax and investment expert to provide guidance on how to structure the investment. If the investor does not follow the rules provided by the IRS when transferring appreciated property, the federal tax agency may consider the transaction a taxable event.
2. Rate of return
DownREITs are preferred over UpREITs when the property owner expects their property to appreciate more than the REIT’s entire portfolio. A DownREIT acts as a joint venture between a REIT and a property owner, and only the property owner’s assets are held at the partnership level. The performance of the partnership does not go hand-in-hand with the performance of the REIT’s entire portfolio of real estate properties.
When exercising the put option, the conversion is pegged on the value of the partnership’s assets at the time of conversion and not the partnership’s assets. On the other hand, the partnership units held by an investor in an UpREIT rise and fall with the REIT’s shares and may result in a loss if the shares lose value at the time of conversion.
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