Editor’s be aware: That is half considered one of a two-part collection about pressured Part 721 UPREIT conversions when a Delaware statutory belief (DST) goes full-cycle and reaches the tip of its maintain interval. Half two will talk about the flip facet of those pressured conversions, in addition to most well-liked options.
IMPORTANT MEMORANDUM
TO: All 1031 trade, 721 trade UPREIT and Delaware statutory belief buyers
FROM: Dwight Kay, founder and CEO of Kay Properties & Investments
SUBJECT: Dangers of pressured DST-UPREIT conversions
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EXECUTIVE SUMMARY
In current Delaware statutory belief (DST) choices, some sponsors embrace pressured Part 721 UPREIT conversions into perpetual-life REITs (non-traded REITs) on the finish of the DST’s maintain interval.
Beneath this construction, buyers obtain probably illiquid REIT (actual property funding belief) working partnership (OP) items as an alternative of money.
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This memo outlines the important thing dangers of pressured UPREITs (umbrella partnership REITs) and explains why buyers ought to prioritize conventional DSTs or DSTs with absolutely elective 721 UPREIT elections.
Listed here are 4 key dangers of pressured DST 721 UPREIT conversions:
1. Lack of management over exit
In a pressured DST 721 UPREIT situation, buyers haven’t any alternative within the exit technique — you need to trade your DST pursuits for REIT working partnership items on the sponsor’s phrases.
The timing and phrases won’t align along with your private monetary technique, and also you successfully lose flexibility to decide on whether or not or when to money out or proceed deferring taxes.
Buyers are basically locked in to the UPREIT with out the power to alter course or pursue a unique 1031 trade at sale.
Buyers who take part in a pressured 721 UPREIT put themselves right into a state of affairs by which they will not be capable to consider the well being of the final-destination REIT on the time of the 721 transaction.
That is problematic as a result of the final-destination REIT would possibly seem wholesome on the time of the DST transaction, however when the DST is named into the 721 trade transaction in a couple of years, the final-destination REIT might probably have a very completely different monetary image and threat profile.
2. Restricted liquidity and redemption dangers
Non-traded, perpetual-life REITs ensuing from a 721 UPREIT conversion provide very restricted liquidity in contrast with an easy property sale. The partnership items you obtain are illiquid — they don’t seem to be publicly traded and cannot be rapidly transformed into money.
Whereas many non-traded REITs provide periodic redemption applications, these applications are usually restricted and never assured as per the REIT’s providing paperwork. Such share redemption plans may be capped, oversubscribed, even suspended, particularly in instances of market stress.
Regulators typically warning buyers that non-traded REITs typically contain an absence of liquidity and generally embrace unsure early redemption provisions for buyers.
In a pressured UPREIT, this implies you would be unable to liquidate your funding by yourself timetable. Even worse, if many buyers search to redeem, the REIT would possibly merely halt redemptions, as has occurred with some giant perpetual-life REITs.
You hand over the assured liquidity of a sale, and your means to money out is dependent upon the REIT’s restricted redemption insurance policies (which the REIT can alter or pause at its discretion).
Lots of the largest non-traded perpetual-life REITs have gated their liquidity provisions. Buyers who may need been instructed they’d have entry to liquidity by their monetary adviser may be caught with an illiquid actual property providing. It might take them months or years to entry liquidity.
3. Valuation opacity
A perpetual-life DST-sponsored REIT typically makes use of internally assessed internet asset values (NAVs) for its shares, which introduces valuation opacity.
Since there isn’t any lively market setting a clear value, buyers should depend on sponsor-provided and commissioned value determinations or NAV calculations, which might lack the transparency of open market pricing.
In a pressured conversion, you give up an easy payout (sale proceeds at market worth) for an opaque stake in a bigger portfolio.
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Figuring out what your new REIT items are really value may be tough, and the valuation may be topic to conflicts of curiosity, because the sponsor is on either side of the DST-to-REIT transaction. This opacity can obscure whether or not you are getting truthful worth in your DST property.
In distinction, a direct property sale to an unaffiliated third social gathering establishes a transparent market worth in your funding.
4. Tax deferral dangers
Whereas a 721 UPREIT conversion itself is mostly not a taxable occasion, it will possibly introduce complicated tax dangers down the road.
When you maintain REIT working partnership (OP) items, you possibly can not do a 1031 trade on that funding, as OP items do not qualify as like-kind property for 1031 functions.
This implies a pressured UPREIT successfully cuts off your means to proceed deferring capital good points tax through future 1031 exchanges.
In consequence, your tax deferral will finish while you ultimately liquidate your REIT items. Any conversion of your OP items into REIT shares or money redemption is a taxable occasion that may set off the capital good points you had deferred.
In different phrases, the tax invoice is delayed however not eradicated, and you may encounter it once more when exiting the REIT. You will additionally lose management of the timing of that taxable occasion.
If the REIT later forces a merger or compels conversion of your OP items to frequent shares, you would be hit with a poorly timed taxable capital achieve.
There’s additionally the danger that the REIT’s working partnership would possibly promote the underlying property you contributed, and with out cautious structuring or tax safety agreements, such a sale might unexpectedly set off taxable good points to you as an OP unit holder.
In abstract, a pressured UPREIT can create an inevitable tax legal responsibility and take away the 1031 exit ramp that DST buyers typically depend on to repeatedly defer taxes.
Many DST 721 UPREIT sponsors clearly state of their providing paperwork that they will not present a tax safety settlement to their buyers.
This would depart the buyers uncovered. If the REIT have been to promote its DST property that the DST buyers contributed through a 721 trade to the REIT, it might be pressured to pay capital good points taxes on that contributed property.
Partly two of this collection, I’ll talk about the flip facet of those pressured conversions and describe why I firmly imagine absolutely elective UPREIT conversions are far superior and what buyers ought to pay attention to earlier than investing in any 721 UPREIT trade.
Associated Content material
This text was written by and presents the views of our contributing adviser, not the Kiplinger editorial workers. You may verify adviser data with the SEC or with FINRA.
