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Take My Property, Please -- Doing A Deal With A REIT

An examination of a typical REIT transaction with a focus on the tax issues that must be dealt with in considering the options available to individuals and S Corporations who are partners in real estate partnerships.

The growth of real estate investment trusts (REITs) in the 1990's (and their need for continuous growth) has presented real estate owners with many opportunities and resulted in numerous transactions over the last several years. REIT transactions can be very enticing since they provide real estate diversification and a public-vehicle exit strategy. Due to hefty values and large built-in gains inherent in many of the properties attractive to REITs, structuring the transactions in the most tax-efficient manner has become of paramount importance. In negotiating these deals it is important to be aware of the tax issues that exist to avoid not only immediate, but also future, adverse tax consequences. This article will examine a typical transaction and highlight the tax issues that must be dealt with in considering the options available to individuals and S corporations who are partners in real estate owning partnerships.⁽¹⁾

UPREIT Structure. At the forefront of the REIT ground swell of the 1990's is an innovation called the umbrella partnership real estate investment trust (UPREIT). In the classic REIT format, the REIT owns real property directly. While this format has the advantage of simplicity, under Section 351(e),⁽²⁾ contributors of property to the REIT cannot avoid recognition of gain when appreciated property is contributed to the REIT.⁽³⁾ The UPREIT was developed in response to this problem. Under the UPREIT format, instead of contributing properties directly to a REIT, property owners contribute properties and the REIT contributes cash to an umbrella partnership (the "operating partnership") in exchange for operating partnership interests ("Units"). The REIT's cash is used to pay down debt, make improvements, acquire properties, and/or provide working capital.

Under Section 721, and subject to the discussion below, contributors do not realize gain upon contribution of properties to the operating partnership. However, the contributors have the right to convert their Units into REIT shares, at which time any built-in gain may be realized. After formation, the operating partnership would be able to acquire additional properties on an ongoing basis without causing gain recognition to the owner by having the owner contribute the property to the operating partnership in return for Units.

Unit Deal Tax Issues

An individual ("A") and an S corporation ("B") each contribute $100 to form Partnership AB. Partnership AB borrows $800 and buys a property for $1,000. At this point, the balance sheet of Partnership AB is as follows:

	Tax	Book
Property	$1,000	$1,000
Total	$1,000	$1,000
Liabilities	$800	$800
Capital:
A	100	100
B	100	100
Total	$1,000	$1,000

 

Over time the partners take $500 of depreciation; assuming the property has not declined in value, AB Partnership's tax, book and fair market value, balance sheets look like this:

	Tax	Book	FMV
Property	$500	$500	$1,000
Total	$500	$500	$1,000
Liabilities	$800	$800	$800
Capital:
A	(150)	(150)	100
B	(150)	(150)	100
Total	$500	$500	$1,000

 

Partnership AB is approached by a REIT (in an UPREIT structure) which wishes to purchase its property. If AB were to sell the property to the REIT, it would have a $500 gain. What options do the partners have if they want to avoid this gain? The simplest option is for the partners to contribute the property to the REIT's operating partnership in exchange for Units. This could take the form of (i) A and B contributing their partnership interests in AB to the operating partnership in exchange for Units or (ii) AB contributing the property to the operating partnership in exchange for Units followed by a liquidating distribution of the Units to A and B.

Since the goal of Unit transactions is to preserve tax deferral, the issues raised in connection with these transactions relate to qualifying the contribution for tax-free treatment under Section 721 initially and to avoiding recognition of the contributor's built-in gain subsequently.

Disguised Sales. Section 707 and the Treasury Regulations thereunder (the "Disguised Sale Regulations") generally provide that, unless one of certain prescribed exceptions is applicable, a partner's contribution of property to a partnership and a simultaneous transfer of money or other consideration from the partnership to the partner will be treated as a sale, in whole or in part, of such property by the partner to the partnership.

For purposes of these rules, certain reductions in a partner's share of liabilities are treated as a transfer of money or other property from the partnership to the partner which may give rise to a disguised sale. However, if a transfer of property by a partner to a partnership is not otherwise treated to any extent as part of a sale, any reduction in the partner's share of "qualified liabilities" (discussed below) is not treated as part of a sale.⁽⁴⁾

For purposes of the Disguised Sale Regulations, a "qualified liability" in connection with a transfer of property to a partnership includes (i) any liability incurred more than two years prior to the earlier of the transfer of the property or the date the partner agrees in writing to the transfer, as long as the liability has encumbered the transferred property throughout the two-year period; (ii) a liability that was not incurred in anticipation of the transfer of the property to a partnership, but that was incurred by the partner within the two-year period prior to the earlier of the date the partner agrees in writing to transfer the property or the date the partner transfers the property to a partnership and that has encumbered the transferred property since it was incurred; (iii) a liability that is traceable under the Treasury Regulations to capital expenditures with respect to the property; and (iv) a liability that was incurred in the ordinary course of the trade or business in which property transferred to the partnership was used or held, but only if all the assets related to that trade or business are transferred, other than assets that are not material to a continuation of the trade or business.⁽⁵⁾

If a transfer of property to a partnership and one or more transfers of money or other consideration (including the assumption or taking subject to a liability) by the partnership to that partner are treated as a disguised sale, then the transaction will be treated as a taxable sale of property, in whole or in part, to the partnership by the partner, rather than a contribution under Section 721 of the Code and a partnership distribution.

Moreover, if a transfer of property to a partnership is treated as part of a sale without regard to the partnership's assumption of or taking subject to a "qualified liability," as defined above, then the partnership's assumption of or taking subject to that liability is treated in part as a transfer of additional consideration to the transferring partner.⁽⁶⁾

A pitfall in many Unit transaction agreements may be hidden in the closing adjustments section. Often, provisions which reduce the number of Units to be received by the contributor on account of certain liabilities which the operating partnership will assume highlight those liabilities which must be examined to determine if they are qualified liabilities under the Disguised Sale Regulations. Likewise, payment by the operating partnership of the contributor's costs in connection with the transaction may result in a partial disguised sale. This issue often arises in the case of brokerage fees, transfer taxes and prepayment penalties. The treatment of brokerage fees and transfer taxes depends upon which party is primarily liable; if the liability falls upon the contributor, then the operating partnership's payment of such liabilities could give rise to a partial disguised sale.

Often in connection with a contribution to an operating partnership, debt is paid down or refinanced and in some cases the existing lenders charge prepayment penalties. Even where the payment is a necessary element of the contribution transaction, when the payment occurs subsequent to the contribution, it would seem that the prepayment penalty is an obligation of the operating partnership even if the consideration (i.e., the Units) is reduced on account thereof and, therefore, the operating partnership can pay it without risking a disguised sale.

Lock-out Provisions. As a result of the tax-free nature of the contribution, the property comes into the operating partnership with a carry-over basis. Pursuant to Section 704(c), income, gain, loss and deduction attributable to appreciated or depreciated property that is contributed to a partnership must be allocated for Federal income tax purposes in a manner such that the contributor is charged with, or benefits from, the unrealized gain or unrealized loss associated with the property at the time of contribution. The amount of such unrealized gain or unrealized loss is equal to the difference between the fair market value of the contributed property at the time of contribution and the adjusted tax basis of such property at that time (referred to as "Unrealized Gain" or "Unrealized Loss"). In a typical Unit transaction there is a substantial amount of Unrealized Gain with respect to the contributed properties. Because of prior depreciation deductions, this may be the case even if the contributed property has not appreciated in value in economic terms. This is illustrated in the case of Partnership AB, where there is $500 of Unrealized Gain at the time of contribution to the operating partnership, even though the property has not appreciated in value.

As a result of Section 704(c), the entire advantage of a tax-free contribution would be lost if the operating partnership were to turn around and sell the property the day after the contribution was made. The operating partnership would realize gain and, pursuant to Section 704(c), would specially allocate that gain to the contributor. To avoid this, the contributor usually negotiates for a period of time during which the contributed property may not be sold (a "lock-out period"). In addition, if the contributor has a negative tax capital account (discussed below) the contributor may also negotiate for a certain minimum level of debt to be maintained on the property during the lock-out period.

Operating partnerships typically resist having their hands tied and, therefore, the length of the lock-out period and the exceptions to the lockout are hotly negotiated. Lock-out provisions may include exceptions for a tax-free exchange or a taxable sale where the contributor is indemnified for the tax consequences of sale. (Note that to make the contributor whole the indemnity would have to be "grossed up" to account for the extra tax the contributor will incur on account of the indemnity payment.) Exceptions may also include sales of the operating partnership's whole portfolio in the geographic area and involuntary transfers such as foreclosures or bankruptcy.

In some cases where the contributor is unable to negotiate an absolute lock-out period or after the lock-out period expires, the operating partnership may agree that if it disposes of the contributed property it will use its "best efforts" to do so in a tax-free format or the operating partnership may give the contributor a right of first offer with respect to the contributed property payable in Units. This right may be structured as a distribution in complete or partial redemption of the contributor's interest in the operating partnership which usually will not trigger the contributor's Unrealized Gain⁽⁷⁾.

Share of Liabilities -- Guarantees

The property owned by Partnership AB, referred to above, was contributed to the operating partnership and the operating partnership took subject to $800 of liabilities. What are the consequences if the Operating Partnership pays down a portion of the debt?

Under Section 752, any decrease in a partner's share of liabilities results in such partner's being deemed to have received a cash distribution from the partnership. Under Section 731, such a partner will recognize taxable gain as a result of such deemed cash distribution to the extent that the deemed cash distribution exceeds such partner's adjusted tax basis in his partnership interest.

In the case of a Unit transaction, the liabilities that the operating partnership takes subject to will give rise to a deemed distribution from the operating partnership to the contributor. A contributor may offset his share of the operating partnership's liabilities against the reduction in his liabilities in determining the amount of the deemed cash distribution from the operating partnership; however, if a contributor is deemed under these rules to receive a (net) cash distribution from the operating partnership in a amount in excess of the basis of the contributed property, the partner recognizes taxable gain⁽⁸⁾. Ordinarily, a contributor's share of second-tier liabilities⁽⁹⁾ will prevent him from receiving a deemed distribution in excess of basis, unless the debt secured by the contributed property is reduced.

In order to increase his share of liabilities in the operating partnership and therefore the basis in his units sufficiently to avoid such gain, a contributor may wish to guarantee a debt of the operating partnership. This will have the effect of such debt being allocated exclusively to the contributor and this additional debt share will increase his basis.⁽¹⁰⁾ Thus, if the operating partnership paid down the debt secured by the property formerly owned by Partnership AB, a deemed distribution would result in gain to A and B, unless their share of debt is sufficiently increased by a share of third-tier liabilities or guarantees of partnership debt.

For economic reasons, contributors prefer to guaranty the safest portion of a relatively large debt. Thus, for example, a contributor might guarantee the safest $10 of an $80 debt, which is secured by property A which is worth $100. The contributor would guarantee that if property A were ever sold for less than $10 he would make up the difference.

The complicated rules with respect to partnership debt sharing sometimes result in the need for increased guarantees in later years when the book value of the contributed property dips below the debt secured by such property. As a result, it may be necessary for some contributors to negotiate for the opportunity to guarantee in the future.

In the case of some REITs, there may be a scarcity of "guaranteeable" debt, especially since many REITs have low leverage and have moved away from specific property debt in favor of credit lines and rated debt. Credit-line debts are not ideal for guarantees since by their very nature credit lines are reduced periodically and a reduction of the outstanding amount on a guaranteed credit line could result in gain to the guarantor. Rated debt or any other debt which is not secured by a specific property but rather is recourse to the operating partnership, raises certain debt allocation issues⁽¹¹⁾.

Section 704(c) Method. Treasury regulations under Section 704(c) (the "Section 704(c) Regulations") require partnerships to use a "reasonable method" for allocation of items affected by Section 704(c) of the Code and outline three reasonable methods -- the traditional method, the traditional method with curative allocations, and the remedial method.⁽¹²⁾ The three methods approved by the Section 704(c) Regulations differ with respect to how efficiently the partnership places the burden of a low tax basis on a contributing partner. It is in the contributor's interest to have the operating partnership select the least efficient method with respect to his contributed property but it is in the REIT's interest to select the most efficient method. These methods determine allocation of both the gain upon disposition of the contributed property and the annual depreciation generated by the property.

There is an added incentive for a contributor to have the partnership select the traditional method if the contributed property has relatively few years left on its depreciation schedule and the operating partnership will continue to use such depreciation schedule. The amount of the maximum potential Section 704(c) allocation (if the contributed property were sold) burns off ratably over the depreciable life of the property, as the book-tax difference with respect to the asset diminishes. Thus, when the depreciable life of the property is over, there is no book-tax difference and, therefore, the contributing partner is no longer vulnerable to a Section 704(c) allocation if the property is sold. A number of operating partnerships have selected the "traditional method with a curative allocation upon the sale of the property" (to the extent that depreciation has previously been limited) under the Section 704(c) Regulations⁽¹³⁾ in order to prevent this benefit to the contributor.

Section 704(c) could also have an impact on debt sharing under Section 752. If the remedial method is selected it usually results in a significant shift of liabilities to the contributing partner. Revenue Ruling 95-41⁽¹⁴⁾ states that a partnership should take Section 704(c) built-in gain into account in its third-tier liabilities allocation. However, the price is recognition of the partner's Unrealized Gain over 39 years (for commercial property) in the form of phantom income allocations.

Receiving Cash Consideration. As the discussion above regarding the Disguised Sale Regulations makes clear, receipt of even a small amount of cash in connection with a contribution to a partnership can taint what would otherwise be a qualified liability and cause a portion (sometimes a relatively large portion) of the Unrealized Gain to be recognized immediately. However it is possible to receive certain cash distributions from the Operating Partnership without jeopardizing the tax-free status of the contribution.

One exception contained in the Disguised Sale Regulations relates to a distribution of debt proceeds. If a partnership makes a distribution of cash to a partner which is traceable to a debt which it incurred within 90 days of such distribution, and such partner bears the risk of loss with respect to such debt then the distribution is not taken into account for purposes of the Disguised Sale Regulations.⁽¹⁵⁾ Thus, if a contributor contributes property to an operating partnership and the operating partnership immediately takes out a loan (which could be secured by such property) which the contributor guarantees, the contributor may receive a distribution of loan proceeds without triggering his Unrealized Gain. The rules involved in such a transaction are complex and technical; thus, the transaction needs to be planned carefully.

Another exception contained in the Disguised Sale Regulations that may be applicable permits the contributor to be reimbursed for preformation expenditures, i.e., certain expenses incurred with respect to the contributed property during the two-year period preceding the contribution⁽¹⁶⁾.

The Merger Alternative

Generally partnerships are the preferred form of real estate ownership for a number of reasons:

(1) Subject to some restrictions, partnerships allow the pass-through of losses to their partners, even those which are generated by debt-financed property. Even though Section 704(d) limits the losses a partner may deduct to such partner's basis, under Section 752, a partner's basis is increased by his share of partnership debt. An S corporation also passes through losses (Section 1366(a)) and such losses are also generally limited by the shareholder's basis (Section 1366(d)(1)); however, the shareholder receives no extra basis for the S corporation's debt (setting aside special rules pertaining to debt owed to shareholders).

(2) Partnerships may make tax-free distributions of appreciated assets, subject to various restrictions contained in Section 704(c)(1)(B), Section 707 and Section 737. Under Section 311, however, gain is generally recognized upon a distribution of appreciated property by an S corporation.

(3) Partnerships allow great flexibility in the allocation of economic and tax items among partners, while the S corporation rules permit only one class of stock, thereby precluding special allocations.

Despite these advantages of the partnership form of ownership there may be an advantage to owning real estate through an S corporation in the context of doing a Unit transaction, since such ownership may permit an alternative to the classic Unit transaction structure.

Anatomy of a Tax-Free Corporate Merger. If a property which a REIT wishes to acquire is held in an S corporation, a tax-free transaction could be structured in the following manner:

(1) The S corporation merges into the REIT. Alternative structures may be used to shield the REIT from the corporate liabilities of the S corporation; for example, the S corporation can merge into a newly formed corporation wholly owned by the REIT. Such a corporation is treated as a qualified REIT subsidiary (a "QRS") under Section 856(i) and is therefore ignored for income tax purposes.

(2) The S corporation shareholders receive REIT shares in the merger.

(3) The REIT (or the QRS) contributes the property so acquired to the operating partnership if the REIT has an UPREIT structure.

Special Issues Raised by Merger Format If the QRS format is used, even though as a matter of local law the S corporation is merging into the QRS and not the REIT, the merger may qualify as a statutory merger under Section 368(a)(1)(A)⁽¹⁷⁾.

Section 357(c) provides that gain is recognized, in what would otherwise be a tax-free exchange, when assets are transferred to a corporation subject to liabilities that, when aggregated with any other liabilities assumed by the corporation, exceed the aggregate basis of the assets transferred. This provision applies to Section 351 contributions and Section 368(a)(1)(D) reorganizations⁽¹⁸⁾. However, Section 357(c) does not apply to Section 368(a)(1)(A) reorganizations. Accordingly, a merger can be accomplished totally free of income tax.

Comparison to OP Unit Deal from The Contributor's Perspective On the whole, a merger transaction will generally be far more attractive to a contributor than a Unit transaction. In doing a merger or other reorganization the contributor will not suffer the tax exposures imposed in the partnership context by Section 704(c); thus, a sale of the property no longer detrimentally affects the contributor. As a result of the merger, the contributor has "removed" appreciated property from an S corporation without a taxable event. This makes it easier for the owner to do estate planning, since he is no longer a shareholder of an S corporation hampered by the S corporation rules (which for example, would prevent him from contributing shares of the S corporation to a family limited partnership). Disposing of the S corporation may avoid the continued application of some local taxes (for example, the New York City General Corporation Tax). Moreover, the contributor now owns REIT shares rather than Units. REIT shares can be leveraged and sold more easily and, for most shareholders, have no special reporting requirements, while ownership of OP units may require the Unit holder to file tax returns in the various jurisdictions in which the operating partnership owns property.

From the REIT's perspective The primary advantage of the merger format for the REIT is that it avoids the need to negotiate a Lock-Out Period or deal with financing restrictions; since the contributor is not detrimentally impacted by a sale of the transferred property or a reduction in the debt, the REIT is unrestricted with respect to sale or financing of such property. However, the REIT is inheriting the corporation's low tax basis and, if the property is sold, the REIT will be allocated all of the Unrealized Gain under Section 704(c). The effect of gain to a REIT is usually to cause a greater proportion of its dividend to be taxable rather than a nontaxable return of capital which reduces basis. It is unclear to what extent REITs are concerned with this problem.

Conclusion

Although property acquisitions by REITs slowed in the latter part of 1998, the factors which drive Unit transactions, large Unrealized Gains for contributors and REITs' hunger for growth, remain. To avoid the strain on a REIT's cash flow, it is likely that the currency of choice will be equity interests - either Units or REIT stock - to effectuate tax-advantaged transactions.

FOOTNOTES________________________

1. As used herein, the term partnership includes limited liability companies which are treated as partnerships for tax purposes.

2. All section references are to the Internal Revenue Code of 1986, as amended, unless otherwise stated.

3. Treas. Reg. Section 1.351-1(c).

4. Treas. Reg. Section 1.707-5(a)(1).

5. Treas. Reg. Section 1.707-5(a)(6).

6. Treas. Reg. Section 1.707-5(a)(5).

7. Sections 731(a)(1), 737(d).

8. See Treas. Reg. Section 1.752-1(f).

9. See Treas. Reg. Section 1.752-3(a)(2).

10. Treas. Reg. Section 1.752-2(b)(1) and Treas. Reg. Section 1.752-2(f), Example 5.

11. See PLRs 9507023, 9815001 and 9815022.

An alternative to a guaranty is a deficit restoration obligation ("DRO"), where a partner guarantees to make up a deficit balance in his capital account up to a certain amount. This can result in an allocation to such a partner of an increased share of partnership recourse liabilities.

12. Treas. Reg. Section 1.704-3. For a detailed discussion see "Exploring the Outer Limits of the 704(c) Partnership Built-in Gain Rule", Rubin and Macintosh, Journal of Taxation (September 1998).

13. Treas. Reg. Section 1.704-3(c)(iii)(B).

14. 1995-1 C.B. 132

15. Treas. Reg. Section 1.707-5(b).

16. Treas. Reg. Section 1.707-4(d).

17. See PLRs 8903074 and 9411035. If the merger were not to qualify under Section 368(a)(1)(A), it might still qualify under Section 368(a)(1)(C). A contemporaneous contribution of the property to the operating partnership may, however, raise "remote continuity of interest" issues. In certain cases it may be possible to structure the transaction so that it qualifies under Section 368(a)(1)(B).

18. A "C" reorganization that also qualifies as a "D" reorganization will be treated as a "D" reorganization for this purpose. A "C" reorganization in which the transferring shareholders do not end up with "control" of the acquiring corporation, however, will not generally qualify as a "D."