real estate contributions to reits tax, legal and ... · •overview of the upreit structure ......

Andrea M. Whiteway. Copyright 2016. 1

Real Estate Contributions to

REITs – Tax, Legal and

Securities Laws Considerations

Stephanie Smith, USDA, Washington DC Theodore Grannatt, McCarter English, Boston, MA

Christopher Roman, Fried Frank, NY, NY Andrea M. Whiteway, EY, Washington, D.C.

2016 RPTE Spring Symposia

Boston, MA


Discussion Points

• Brief Overview of the Tax Consequences of

Real Estate Dispositions

• Overview of the UpREIT Structure

• Tax Aspects of Real Estate Contributions to

Partnerships / Tax Protection Agreements

• Legal Aspects of Real Estate Contributions to

REITs

• Securities Laws Aspects of REIT Contributions

The Rise of the REITS

3

REIT market capitalization 1971 – 2014

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Market Capitalization ($ in bln) # of REITS

Andrea M. Whiteway. Copyright 2016.

The Rise of the REITS

4

REIT issuance 2000 – 2015 YTD

REITs have become an important

investment class

Record breaking amounts of capital

raised by REITs in 2012 and 2013

Capital raised in 2014 saw a 17.3%

decrease but was still far above all

historical levels, excluding 2012 and 2013

2015 is on track to be another record

breaking year – in January and February

alone, there have been 35 offerings for a

total amount of $15.8 bln

– That is far greater than the amount

offered during the same period of

2013 (record high year), and greater

than the amount offered in the entire

first quarter of 2014

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Capital Raised ($ in mm) # of Equity Offerings

Andrea M. Whiteway. Copyright 2016.


What is a REIT?

• CORPORATION, TRUST OR ASSOCIATION

OTHERWISE TAXABLE AS C CORPORATION

• MUST MEET REQUIREMENTS OF SECTION

856 AND ELECT REIT STATUS

• NOT SUBJECT TO CORPORATE TAX TO

EXTENT INCOME IS DISTRIBUTED TO

SHAREHOLDERS


What is an UPREIT?

• “UMBRELLA PARTNERSHIP” REIT

• SUBSTANTIALLY ALL ASSETS ARE OWNED

THROUGH “OPERATING PARTNERSHIP” IN

WHICH REIT IS GENERAL PARTNER

• “OP UNITS” HELD BY LIMITED PARTNERS

ARE CONVERTIBLE INTO REIT STOCK


What is an UPREIT?

REIT

OP

GP

7 MILLION

SHARES

SHAREHOLDERS

CONTRIBUTING

PARTNERS

LP 3 MILLION UNITS

CONVERTIBLE

INTO 3 MILLION

SHARES


Why an UPREIT?

• UPREIT STRUCTURE FIRST USED IN 1992 IN

TAUBMAN REALTY CENTERS IPO

• OF THE 170 PUBLICLY TRADED REITS, 98

ARE UPREITS

• MOST EQUITY REITS ARE UPREITS


Transfer to REIT

APPRECIATED

REAL ESTATE

REIT

CASH

PUBLIC PROPERTY

OWNERS


Transfer to REIT

• EXCEPT AS SPECIFICALLY MODIFIED BY

REIT RULES, SUBCHAPTER C APPLIES

• SECTION 351(a) GENERALLY PROVIDES FOR

NONRECOGNITION TREATMENT ON

TRANSFERS TO CORPORATION

• BUT SECTION 351(e) EXCEPTION FOR

INVESTMENT COMPANIES


Transfer to REIT

• INVESTMENT COMPANY IF 80% OF ASSETS

STOCKS AND SECURITIES AND TRANSFER

RESULTS IN DIVERSIFICATION

• STOCKS AND SECURITIES BROADLY

DEFINED UNDER ‘97 ACT

• REGULATIONS SAY REIT IS PER SE

INVESTMENT COMPANY


Transfer to REIT

• DIVERSIFICATION RESULTS IF ONE PERSON

TRANSFERS CASH AND ANOTHER

TRANSFERS REAL ESTATE

• REGULATORY EXCEPTION FOR TRANSFERS

OF DIVERSIFIED PORTFOLIOS OF

SECURITIES


Transfer to REIT

• REGULATORY EXCEPTION DOES NOT APPLY

TO DIVERSIFIED PORTFOLIOS OF REAL

ESTATE

• BUT SEE PLR 9744003; PLR 9801016; PLR

199947001; PLR 200450018


Transfer to REIT

• SECTIONS 351(a) AND 368(c) REQUIRE

TRANSFERORS TO OWN 80% OF VOTING

STOCK IMMEDIATELY AFTER TRANSFER

• NOT A PROBLEM FOR IPO TRANSACTION,

BUT FOR SUBSEQUENT PROPERTY

ACQUISITIONS


Transfer to REIT

• SECTION 357(c) REQUIRES GAIN

RECOGNITION TO EXTENT OF DEBT IN

EXCESS OF BASIS

• SECTION 856(h) PROHIBITS 5 OR FEWER

INDIVIDUALS FROM OWNING 50% OR MORE

OF REIT


UPREIT Structure

APPRECIATED

REAL ESTATE

REIT

CASH

PUBLIC

PROPERTY

OWNERS

OP

CASH GP LP


UPREIT Structure

• MONEY RAISED IN IPO IS USED TO PAY

DOWN DEBT AND/OR FOR ACQUISITIONS

• OP UNITS ARE CONVERTIBLE INTO STOCK

OF PUBLICLY TRADED REIT OR CASH AT

REIT’S OPTION

• AVOIDS SECTION 351(e), 368(c), 357(c) AND

856(h) PROBLEMS


Partnership Anti-Abuse

Regulation

• If a partnership is formed or availed of in

connection with a transaction a principal

purpose of which is to reduce substantially

the present value of the partners’ aggregate

federal tax liability in a manner that is

inconsistent with the intent of Subchapter K,

• Then the Commissioner can recast the

transaction as appropriate.


Partnership Anti-Abuse

Regulation

• EXAMPLE 4 DESCRIBES AN UPREIT

TRANSACTION AND “BLESSES” IT

• WHILE THERE ARE DIFFERENCES BETWEEN

EXAMPLE 4 AND THE TYPICAL UPREIT

STRUCTURE, GIVEN THE NUMBER OF

DEALS, CHALLENGE IS UNLIKELY


Conversion Right

• OP UNITHOLDER IS PERMITTED TO

EXCHANGE ONE OP UNIT FOR ONE SHARE

OF REIT STOCK

• REIT MUST HAVE ELECTION TO PAY CASH

TO AVOID OPTION ATTRIBUTION

• RECEIPT OF CONVERSION RIGHT AS BOOT?

SEE REV. RUL. 69-265


Conversion Right

• CONVERSION RIGHT PROVIDES LIQUIDITY

• EXERCISE OF CONVERSION RIGHT WITHIN 2

YEARS MAY TRIGGER DISGUISED SALE

TREATMENT IF STOCK OR CASH COMES

FROM OP


Conversion Right

• FORM OF CONVERSION IS CRITICAL

• CASH OR STOCK FROM OP = REDEMPTION

(IF FORM IS RESPECTED)

• CASH OR STOCK FROM REIT = SALE (IF

FORM IS RESPECTED)


Conversion Right

• BENEFITS OF REDEMPTION TREATMENT:

• REDEMPTION OF SOME BUT NOT ALL

UNITS

• 15% CAPITAL GAINS RATE VS. 25%

RATE FOR UNRECAPTURED SECTION

1250 GAIN


Section 704(c)

• SECTION 704(c) APPLIES TO PROPERTY

CONTRIBUTED TO OP

• BUILT-IN GAIN ON PROPERTY WILL BE

ALLOCATED BACK TO CONTRIBUTING

PARTNER ON SALE

• DEPRECIATION WILL BE ALLOCATED AWAY

FROM CONTRIBUTING PARTNER


Traditional Method

• CEILING RULE APPLIES

• CONVENTIONAL WISDOM: MAXIMIZES

DEFERRAL OF INCOME TO CONTRIBUTING

PARTNER

• BUT RUN THE NUMBERS


Curative Allocation Method

• NO CEILING RULE

• MINIMIZES DEFERRAL OF INCOME TO

CONTRIBUTING PARTNER

• MAXIMIZES DEDUCTIONS TO REIT AND

OTHER LPs


Remedial Allocation Method

• NO CEILING RULE

• INTERMEDIATE DEFERRAL OF INCOME TO

CONTRIBUTING PARTNER (MORE THAN

CURATIVE BUT LESS THAN TRADITIONAL)


Example • CONTRIBUTED PROPERTY HAS $100 VALUE,

$30 BASIS, 10-YEAR REMAINING LIFE, 39-

YEAR NEW LIFE; GETS 1% OP INTEREST

INCOME TO DEDUCTION TO

CONTRIBUTOR REIT

TRADITIONAL $0 ($3)

CURATIVE $6.90 ($9.90)

REMEDIAL $1.75 ($4.75)


Encumbered Property

• CASH DISTRIBUTIONS IN EXCESS OF BASIS

IN PARTNERSHIP ARE TAXABLE

• REDUCTION IN SHARE OF LIABILITIES

TREATED AS CASH DISTRIBUTION

• IF LIABILITIES IN EXCESS OF BASIS, MUST

MAINTAIN SHARE OF LIABILITIES EQUAL TO

NEGATIVE CAPITAL ACCOUNT


Encumbered Property

• EXAMPLE: CONTRIBUTE PROPERTY WITH

BASIS OF $40, SUBJECT TO DEBT OF $100

• BASIS IN PARTNERSHIP IS $40, REDUCED BY

DEEMED DISTRIBUTION FROM DEBT SHIFT

• FOR DEEMED DISTRIBUTION NOT TO

EXCEED $40, MUST KEEP AT LEAST $60 OF

DEBT (= TO NEGATIVE CAPITAL ACCOUNT)


Recourse Debt

• PARTNER’S SHARE OF RECOURSE DEBT

BASED ON ECONOMIC RISK OF LOSS

• ECONOMIC RISK OF LOSS DETERMINED

UNDER CONSTRUCTIVE LIQUIDATION “ATOM

BOMB” TEST


Nonrecourse Debt

• THREE TIERS:

• PARTNERSHIP MINIMUM GAIN

• SECTION 704(c) MINIMUM GAIN

• EXCESS IN ACCORDANCE WITH

PROFITS


Nonrecourse Debt

• IMPACT OF SECTION 704(c) METHOD ON

SECOND TIER -- REV. RUL. 95-41

• THIRD-TIER SEC. 704(c) “FILL-UP”

ALLOCATION – 10/30/2000 AMENDMENT


Nonrecourse Debt

• ON CONTRIBUTION OF PROPERTY SUBJECT

TO NONRECOURSE DEBT, PARTNER WILL

ALWAYS KEEP ENOUGH DEBT

• PROBLEM IS PAYDOWN, CROSS-

COLLATERALIZATION, REFINANCING, ETC.


Preserving Share of Debt

• GUARANTEE OF NONRECOURSE LIABILITY

CAUSES IT TO BE IN GUARANTEEING

PARTNER’S BASIS

• “BOTTOM GUARANTEE” MINIMIZES

ECONOMIC EXPOSURE


Bottom Guarantee

• EXAMPLE: PROPERTY HAS VALUE OF $100,

IS SUBJECT TO NONRECOURSE DEBT OF

$60

• TAXPAYER GUARANTEES THE “BOTTOM

$20”

• TAXPAYER ONLY LIABLE IF PROPERTY

DECLINES IN VALUE TO LESS THAN $20


DRO

• CAPITAL ACCOUNT DEFICIT RESTORATION

OBLIGATION WILL NOT SHIFT

NONRECOURSE DEBT

• IF ACCOMPANIED BY LOSS ALLOCATION, IT

WILL SHIFT RECOURSE DEBT


Indemnity

• GUARANTEE OF RECOURSE DEBT WILL NOT

SHIFT IT -- SEE REG. SEC. 1.752-2(f)

EXAMPLE 3

• INDEMNITY OF GENERAL PARTNER (OR DRO

AND LOSS ALLOCATION) IS REQUIRED TO

SHIFT RECOURSE DEBT


Term of Guarantee/Indemnity

• TERMINATION UPON CONVERSION OF OP

UNITS INTO STOCK MAY BE PROBLEMATIC

• TERM OF YEARS, WITH EXTENSION TERMS

• APPRAISAL OF PROPERTY AT EXPIRATION?


At-Risk Problems

• SEC. 465(a) LIMITS LOSSES OF INDIVIDUALS

AND CLOSELY HELD C CORPS TO AMOUNT

AT RISK

• AT RISK RULES EXTENDED TO REAL ESTATE

IN MODIFIED FORM IN 1986


At-Risk Problems

• UNDER SEC. 465(e), IF AMOUNT AT-RISK

REDUCED BELOW $0 AT YEAR END, PRIOR

LOSSES RECAPTURED

• GUARANTEE SHOULD CREATE AMOUNT AT

RISK, BUT DOES IT? SEE PROP. REG. SEC.

1.465-6(d); ABRAMSON, 86 T.C. 360 (1986)


At-Risk Problems

• DRO SHOULD CREATE AMOUNT AT RISK,

BUT DOES IT? SEE HUBERT ENTERPRISES,

125 T.C. 72 (2005)


At-Risk Problems

• “QUALIFIED NONRECOURSE FINANCING”

TREATED AS AT RISK FOR REAL ESTATE

• QNF MUST BE BORROWED FROM

“QUALIFIED PERSON” OR GOVERNMENT, BE

SECURED BY PROPERTY


At-Risk Problems

• “QUALIFIED PERSON” MUST BE ACTIVELY

AND REGULARLY ENGAGED IN BUSINESS

OF LENDING MONEY

• DOES PUBLICLY OFFERED DEBT QUALIFY?

• DOES “EXCULPATORY” (UNSECURED) DEBT

QUALIFY?


At-Risk Problems • FINAL QNF REGS ON LIMITED QUESTIONS

ISSUED AUGUST 4, 1998 – ALLOW

EXCULPATORY DEBT; DISREGARD PERSONAL

LIABILITY OF REAL ESTATE PARTNERSHIPS

• PLRS 9815001 AND 9815022 -- EXCULPATORY

(UNSECURED) DEBT QUALIFIES; DISREGARD

STEP-TRANSACTION DOCTRINE WHERE

UNDERWRITER RE-SELLS DEBT


Marketable Securities

• UNDER SEC. 731(c), DISTRIBUTIONS OF

MARKETABLE SECURITIES ARE TREATED

LIKE CASH

• OP UNITS MAY CONSTITUTE MARKETABLE

SECURITIES BECAUSE OF CONVERSION

RIGHT


Marketable Securities

• IF PROPERTY PARTNERSHIP DISTRIBUTES

OP UNITS PRO RATA, AND NO

INSIDE/OUTSIDE BASIS DIFFERENCE, NO

GAIN SHOULD BE RECOGNIZED

• EXCEPTION SHOULD ALSO APPLY TO NON

PRO RATA DISTRIBUTION OF OP UNITS BY

PROPERTY PARTNERSHIP WITHIN 5 YEARS

OF RECEIPT


Protecting Deferral

• SALE OF CONTRIBUTED PROPERTY WILL

TRIGGER GAIN UNDER SEC. 704(c)

• AS GP, THESE EVENTS ARE GENERALLY

WITHIN REIT’S CONTROL

• PAYDOWN OF DEBT, REFINANCING, CROSS-

COLLATERALIZATION, ETC. CAN ALSO

TRIGGER GAIN


Lock-outs • REIT AND CONTRIBUTING PARTNER OFTEN

AGREE TO A “LOCK-OUT” PERIOD DURING

WHICH OP CANNOT SELL, REFINANCE, ETC.

• TYPICAL LOCK-OUT PERIOD IS 5 TO 15

YEARS

• LOCK-OUT UNTIL DEATH?


Make-Whole Payment

• UPON PROHIBITED EVENT PRIOR TO LOCK-

OUT EXPIRATION, REIT GENERALLY MUST

MAKE “MAKE-WHOLE” PAYMENT

• PAYMENT MAY BE 100% OF TAX, OR ONLY

COMPENSATE FOR PRESENT VALUE HARM

• FORMULA ISSUES -- GROSS-UP, ACTUAL VS.

HYPOTHETICAL TAX, DISCOUNT RATE, ETC.


Carve-Outs

• REIT MAY NEGOTIATE FOR CARVE-OUTS

FOR INVOLUNTARY EVENTS --

FORECLOSURE, CONDEMNATION, ETC.

• CARVE-OUT FOR SEC. 1031 EXCHANGES

• “SHARE-THE-PAIN” PROVISIONS; RATING

AGENCY CONCERNS


Additional Protections

• SEC.1031 LIKE-KIND EXCHANGE AND SEC.

1033 INVOLUNTARY CONVERSION “BEST

EFFORTS” UNDERTAKINGS AFTER LOCK-

OUT

• RIGHT OF FIRST OFFER USING OP UNITS AS

CURRENCY AFTER LOCK-OUT


Going Private Issues

• 15 REIT GOING PRIVATE TRANSACTIONS

ANNOUNCED IN FIRST QUARTER 2006

• TYPICALLY STRUCTURED AS TAXABLE

ASSET PURCHASE (FORWARD CASH

MERGER)



• WILL OP UNIT HOLDERS BE FORCED TO

ACCEPT CASH, TRIGGERING GAIN?

• IF NOT, HOW WILL LIQUIDITY BE ENSURED

AFTER ENTITY IS NO LONGER PUBLICLY

TRADED?

• WHAT DISTRIBUTIONS WILL OP UNIT

HOLDERS GET GOING FORWARD – NO

LONGER TIED TO COMMON DIVIDEND



• OP UNITHOLDER WISH LIST:

• RIGHT TO RECEIVE SAME CASH AS

SHAREHOLDERS

• RIGHT TO HOLD OP UNITS TO AVOID

TRIGGERING GAIN

• RIGHT TO CONTINUED LOCK-OUT,

DEBT AND INDEMNITY PROTECTION



• OP UNITHOLDER WISH LIST:

• RIGHT TO PUT UNITS TO DEEP POCKET

AT FORMULA PRICE

• RIGHT TO DISTRIBUTION PREFERENCE

IF HOLD UNITS


Extracting Cash

• WHERE TARGET PROPERTY IS OWNED BY

PARTNERSHIP, SOME PARTNERS MAY WANT

OP UNITS AND OTHERS CASH

• PARTNERS IN PROPERTY PARTNERSHIP

WHO ARE NOT “ACCREDITED” MUST

RECEIVE CASH UNDER SEC RULES


Extracting Cash

• TRANSFERRING THE PROPERTY TO THE OP

FOR OP UNITS AND CASH WILL TRIGGER A

PORTION OF THE TAXABLE GAIN

• PARTNERS WILL WANT TO SPECIALLY

ALLOCATE TAXABLE GAIN TO PARTNERS

RECEIVING CASH


Extracting Cash • IF PROPERTY PARTNERSHIP IS LIQUIDATED

OR THERE IS A “BOOK-UP,” THE

ALLOCATION MAY FAIL “SUBSTANTIALITY”

• SALE OF PARTNERSHIP INTERESTS MAY BE

RECAST UNDER MERGER RULES

• REG. SEC. 1.708-1(c)(4) ALLOWS PARTNER

WHO GETS THE CASH TO RECOGNIZE ALL

THE GAIN


Extracting Cash

• GENERALLY, IF PROPERTY OWNER

RECEIVES CASH AND OP UNITS, GAIN WILL

BE TRIGGERED UNDER DISGUISED SALE

RULES

• HOWEVER, TECHNIQUES EXIST TO AVOID

DISGUISED SALE TREATMENT


Extracting Cash

• CHERRY PICKING -- SALE OF HIGH BASIS

PROPERTY, CONTRIBUTION OF LOW BASIS

PROPERTY

• PRECONTRIBUTION LEVERAGE AND

GUARANTEE


Extracting Cash

• REIMBURSEMENT OF PREFORMATION

CAPITAL EXPENDITURES

• LEVERAGED DISTRIBUTION AND

GUARANTEE


Preferred Unit Deals

• PREFERRED OP UNITS ENTITLED TO

PRIORITY DISTRIBUTIONS FROM

OPERATIONS AND ON LIQUIDATION

• POPULAR WHEN REIT COMMON STOCK

PRICES NOT DOING WELL



• MAY BE CONVERTIBLE INTO PREFERRED

STOCK WITH SIMILAR RIGHTS OR INTO

COMMON OP UNITS AND THEN COMMON

STOCK

• REIT MAY HAVE “OVERRIDE” TO GET

DISTRIBUTIONS NEEDED TO RETAIN REIT

STATUS



• TO EXTENT NOT CONVERTED,

MANDATORILY REDEEMABLE AFTER 5 TO 7

YEARS (TYPICALLY)

• CONVERTIBILITY INTO COMMON UNITS

GIVES UPSIDE “KICKER” VALUABLE UNDER

BLACK-SCHOLES MODEL


Preferred Unit Deals • CONVERSION INTO COMMON UNITS SHOULD

NOT TRIGGER ADVERSE TAX

CONSEQUENCES – SEE PROPOSED

REGULATIONS ON NONCOMPENSATORY

PARTNERSHIP OPTIONS

• PARTNERSHIP SWAP FUNDS ALSO BUYING

NONCONVERTIBLE PREFERRED UNITS FOR

CASH



• DISGUISED SALE ISSUES

• 150% OF AFR SAFE HARBOR FOR

PREFERRED RETURNS

• MANDATORY REDEMPTION FEATURE

• GROSS VS. NET INCOME ALLOCATIONS

• EFFECT OF CONVERTIBILITY


DOWNREIT Structure

DOWNREIT

PSHP.

GP

PROPERTY OWNERS

LP REIT

ASSETS / PARTNERSHIPS

CASH

APPRECIATED

REAL ESTATE


DOWNREIT Terms

• LPs GET NUMBER OF UNITS EQUAL TO

PROPERTY VALUE DIVIDED BY STOCK PRICE

• EACH UNIT GETS PREFERRED RETURN

EQUAL TO DIVIDEND ON SHARE OF STOCK

• EACH UNIT CONVERTIBLE INTO ONE SHARE

OF STOCK


DOWNREIT Issues

• SHOULD LPs BE TREATED AS RECEIVING

REIT STOCK -- TAXABLE?

• IS RECEIPT OF CONVERSION RIGHT TAXABLE

“BOOT” UNDER DISGUISED SALE RULES?


DOWNREIT Issues

• IF NO RESIDUAL INTEREST AFTER

PREFERRED RETURN, DISGUISED SALE?

• IF GP FUNDS PREFERRED RETURN,

DISGUISED SALE?


Other Legal and

Securities

Considerations

real estate contributions to reits tax, legal and ... · •overview of the upreit structure ......

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