What Is DownREIT?

DownREIT is a joint endeavor between a real estate owner and a real estate investment trust (REIT) for the purpose of acquiring and controlling real estate.

Key Takeaways

  • A DownREIT is a partnership agreement between an REIT and a real estate owner that enables deferring of tax on sale of appreciated real estate.
  • There are two types of DownREITs. The first type involves limited to no capital contributions from REITs while the second type involves significant capital contribution by REITs.
  • DownREITs are more complicated as compared to UPREITs and can have tax implications, if the operating unit is considered a security by the IRS.

Understanding DownREIT

DownREIT involves a partnership arrangement between a real estate owner and the (REIT) that assists the real estate owner in deferring capital gains tax on the sale of appreciated real estate. The UPREIT was invented after the real estate recession of the 1990s to facilitate investment of capital into the real estate industry. DownREIT evolved out of the UPREIT.

Real estate owners who contribute property to DownREITs receive operating units in a partnership. This partnership entity and the property owner's relationship to it can be structured in a variety of different ways, depending on the structure of the REIT and any UPREITs that may exist. In a DownREIT, the REIT has to agree to a standstill or lockout agreement for sale of contributed assets.

There are two types of DownREIT partnership categories. In the first type of partnership, the REIT provides limited to no capital and limited partners receive preferences on distribution of operating cash in an amount equal to REIT share dividends. The second category of REIT involves contribution of significant capital by the REIT. The general partner receives distribution equal to return of capital.

DownREIT Compared to UPREIT

The DownREIT is less widely used than the UPREIT because it is more complicated and may not have the same tax advantages as an UPREIT. Contributing property to a DownREIT is a complex transaction requiring professional tax and investment guidance. If the transaction is not structured with extreme care, the IRS may consider the transfer of property into the DownREIT in exchange for operating units to be a taxable transaction under disguised-sale or anti-abuse rules. Hence, an UPREIT may be the more logical choice for a property owner whose primary concern is to defer income tax liability.

Unlike UPREITs, where ownership of real estate is not involved, a DownREIT does involve owning real estate. Some of this property is owned outright, while some may be owned through limited partnerships with those who have contributed property to it.

A DownREIT can be a logical option if the property owner thinks his real estate will appreciate more than the REIT's other holdings, because he retains a greater interest in his contributed property with a DownREIT than he would with an UPREIT.

That said, since the ownership structure of a DownREIT is more complex, converting operating units to cash requires more complex calculations. Likewise, UPREITs and DownREITs perform differently as investments since they are structured differently. With a DownREIT, the partnership between the REIT and the investor can perform differently than the performance of the REIT as a whole.

DownREITs are similar to UPREITs, however, in their value as an estate planning tool. Both step up the basis of the operating units upon the owner's death, allowing a tax-free transfer of appreciated real estate to heirs. Heirs can then convert the operating units into REIT shares or cash without paying tax.

Example of DownREIT

Consider a portfolio of five properties valued at $100 million. The properties have debt equal to $80 million at 8% interest rate. The partners who own the property have a cumulative capital account balance of $5 million. The REIT enters the transaction and pays off $60 million of existing debt for the property and replaces capital account balances for the remaining partners with debt at 7%. Shares are issued as operating units for the remaining $20 million held by partners and the REIT becomes the majority holder while the remaining partners become GPs and LPs.