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  • Writer's pictureRealFacts Editorial Team

The Next Phase in Tax-Advantaged Real Estate Investments

Hand on coin stacks

In recent years, a novel approach to the traditional UPREIT (Umbrella Partnership Real Estate Investment Trust) structure has been gaining traction, offering significant benefits to smaller real estate owners. This innovative method, known as the DST to UPREIT transaction, is revolutionizing the landscape of tax-advantaged real estate investments.

The Emergence of DSTs in Real Estate

The Delaware Statutory Trust (DST) has long been a favored vehicle for real estate investments under Section 1031 of the Internal Revenue Code. This provision allows real estate owners to defer taxes when they sell a property and reinvest the proceeds into a qualifying replacement property. DSTs offer a turnkey management solution, particularly appealing to older real estate owners seeking relief from the burdens of property management.

However, the DST structure comes with certain limitations. For instance, DST properties must be sold when their mortgage matures, typically every ten years. Recapitalization or refinancing is not permitted, even if it would benefit investors. These structural constraints often force sales at inopportune times, despite investor satisfaction with the property.

The DST to UPREIT Transition

To address these limitations, a new phase in real estate investment has emerged: the transition from DST to UPREIT. In this model, DST owners can contribute their interests to an operating partnership within a REIT, thereby exchanging their DST interests for operating partnership (OP) units.

This transition leverages several favorable partnership tax rules, notably under Section 721, which allows for the contribution of property without triggering taxable gains for either the contributors (property or DST owners) or the recipient (operating partnership). This means the operating partnership can assume the contributor’s mortgage debt or repay it, and contributing owners retain their tax benefits, such as depreciation and operating expense deductions.

Advantages of the UPREIT Structure

The UPREIT structure offers numerous advantages that make it an attractive option for real estate investors. One significant benefit is increased transparency. REITs typically have boards with a majority of independent directors, audited financial statements, rigorous oversight of major decisions, and sponsor compensation.

Additionally, the UPREIT model provides a liquidity option unavailable under the DST structure. OP holders can exchange their units for REIT stock, which can then be sold, thus creating liquidity. In contrast, DST investors must wait until the property is sold, often up to ten years, before they can access their capital.

Flexibility for Estate Planning and Gifting

The UPREIT structure also offers enhanced flexibility for estate planning and gifting. OP units can be divided and distributed among heirs or partners, allowing each individual OP holder to decide whether to hold, gift, or sell their units. This flexibility is a significant advantage over the more rigid DST structure.

The Two-Step Process

While Section 1031 does not allow for a direct exchange into an UPREIT, investors can achieve this through a two-step process: first, a Section 1031 exchange into a DST, followed by a DST to UPREIT transaction. This method allows investors to benefit from the advantages of both structures in a tax-advantaged manner.

Benefits of DST to UPREIT Transactions

- Increased Distributions: Based on the appreciated value of the contributed DST property.

- Diversification: Access to a more diversified investment portfolio managed by the REIT.

- Future Appreciation: Potential for additional capital improvements to increase property value.

- Transparency: High levels of transparency typical of REITs.

- Liquidity: The option to sell OP units, providing liquidity not available in DST structures.

- Tax Benefits: Retention of tax benefits, including depreciation and deductions.

- Long-Term Hold: The ability to hold properties long-term, beyond the typical ten-year mortgage maturity.

- Assumption of Favorable Debt: The capability to assume favorable DST loans.

- Lower Fees: Reduced management and operational fees.

- No Taxable Gain: All these benefits are achieved without any taxable gain under Section 721.

A New Era in Real Estate Investment

The evolution of real estate investment structures continues, with the DST to UPREIT transaction representing a significant advancement. This approach allows investors to upgrade their single-property DST investments to interests in a diversified portfolio of investment-grade real estate, enjoying the benefits traditionally reserved for institutional investors. This innovative progression is transforming the real estate sector, making it an exciting time for investors and industry professionals alike.


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