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Benefits of a Tax-Deferred UPREIT Transaction in Healthcare Real Estate

WHAT IS A REIT?

A REIT, or Real Estate Investment Trust, is a type of investment vehicle that owns and operates income-producing real estate, such as healthcare facilities. REITs are required to distribute at least 90% of their taxable income to shareholders as dividends, making them a popular choice for income-focused investors. REITs can be publicly traded on stock exchanges or privately held and can be focused on a particular type of property or a geographically specific region. 

WHAT IS AN UPREIT?

An UPREIT, or Umbrella Partnership Real Estate Investment Trust is a type of real estate investment structure that allows a property owner to sell their healthcare real estate assets to a REIT while deferring the capital gains tax on the sale. In an UPREIT structure, the property owners contributes the property to a limited partnership, in exchange for a partnership interest. The REIT then holds a majority interest in the limited partnership, and the property owner holds a minority interest on a tax-free basis. 

WHAT IS AN UPREIT TRANSACTION?

In an UPREIT transaction‚ property owners contribute their real estate holdings in exchange for ownership units in the operating partnership (“OP Units”). 

UPREIT transactions present a compelling solution for healthcare real estate owners who anticipate a substantial taxable gain from selling a highly appreciated property with a low tax basis. When such real estate is sold or directly transferred to a Real Estate Investment Trust (REIT), it triggers a revaluation of the property's cost basis for the REIT, leading to taxable consequences for the property owner making the contribution. Nevertheless, opting to contribute the property to the operating partnership rather than the REIT allows the contributing property owner to retain the original historical cost basis. 

The primary incentive for a seller entering a UPREIT transaction is that it can be completed on a tax-deferred basis. By contributing their property to the operating partnership, the owner(s) are not required to immediately recognize any gains from the transaction. This is because they receive OP Units in the REIT's operating partnership instead of acquiring stock shares in the REIT. 

In addition‚ in the event that the OP Units are included in the owner's estate, the eventual recipients of these units will benefit from a stepped-up basis equivalent to their value at the time of the owner's death. Consequently, the inherent gain arising from the UPREIT transaction will be exempt from capital gains or income tax for the recipients. This tax deferral or avoidance, depending on the circumstances, provides REITs employing the UPREIT structure with a significant advantage over individuals or entities that are cash purchasers. 

BENEFITS OF AN UPREIT TRANSACTION

There are several benefits to using an UPREIT structure. For the property owner, it allows them to sell their real estate assets and defer the capital gains tax on the sale until they dispose of their partnership interest. 

It also allows them to diversify their investments, while still maintaining some ownership and control over the property. 

  • Tax deferral for property owners facing capital gain tax, especially if they have a low basis 

  • Diversification of assets in a more balanced portfolio of properties 

  • Quarterly income distributions 

  • Contribute investment proceeds to a professionally managed portfolio of properties 

  • Estate simplification and planning with a step-up in basis 

  • Eliminate property management responsibilities 

  • Ownership of liquid real estate 

  • Avoids risk of negative cash flow 

  • Potential to convert liquid, long-term assets into more saleable securities – OP Units - REIT Share - Cash 

  • Indirect ownership of institutional quality assets

HOW LONG IS THE TAX DEFERRED?

The capital gain taxes remain deferred as long as the operating partnership holds the property and the OP Unit Holder holds the OP Units. In other words‚ capital gains taxes become due if: 

(a) the OP Unit Holder exchanges the OP Units for REIT shares; 

(b) the OP Unit Holder exchanges the OP Units for cash; or 

(c) the subject property is sold by the operating partnership. 

In the last instance‚ however, the operating partnership can sell the property as part of a 1031 exchange and avoid the trigger of gain to the OP Unit Holders that contributed the property being sold. 

An appealing aspect of OP Units for tax planning purposes is their ability to be gradually converted, allowing for a more distributed and reduced tax impact. As mentioned earlier, OP Unit Holders retain the option to convert their OP units into REIT shares at a one-to-one ratio. 

It's important to note that such a conversion is deemed a taxable event. Hence, investors have the flexibility to convert their units gradually over time, enabling them to manage their tax liability in smaller, more manageable increments. 

CAN OP UNITS BE SOLD?

OP Unit Holders receive distributions equal to the dividends paid on the REIT shares. 

REIT’s will typically facilitate the exchange of OP Units for REIT shares or for cash‚ either by purchasing the OP Units itself or by arranging sales to third parties. 

However‚ property owners contemplating the use of an UPREIT transaction should plan on a long-term hold (e.g.‚ 5-7 years) of the OP Units in order to make full use of the tax shelter they provide. 

WHO IS A GOOD CANDIDATE FOR UPREIT TRANSACTIONS?

An UPREIT transaction makes sense if a property owner is looking to achieve one or more of the following: 

(a) defer capital gains tax when appreciated real estate is sold; 

(b) eliminate management hassles of owning real estate; 

(c) diversify through ownership of a portfolio of properties; 

(d) own institutional quality real estate; 

(e) receive consistent quarterly income. 

Your Trusted Healthcare Real Estate Partner

CREG | U.S. HEALTHCARE INVESTMENT SALES

Andrew R. Larwood
Managing Partner & Principal 
m: +1 (770) 845-2091
andrew.larwood@capitalre.com 

Allen C. Inman
Managing Partner & Principal
m: +1 (404) 550-7897
allen.inman@capitalre.com

Joshua D. H. Rees
Managing Partner & Principal
m: +1 (858) 312-0657
josh.rees@capitalre.com 

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