Unlocking the Secrets of 721 UpREIT & 1031 Exchange – DEFER CAPITAL GAINS with the 721 Exchange

David Moore: David Moore with Equity Advantage. And today, I’ve got Robert Smith of Peregrine Private Capital. And we’re going to talk about, well, actually, I’m just going to say I do a presentation on end games and we’re in a sort of a market where people might say, “Gee, very happy to sell this stuff, great time to sell, but I really don’t want to buy anything.” And so, I do a presentation on end games, and I go through a variety of things. DSTs are one of them. And if you follow our channels, you’ve seen this gentleman many times in the past. So, we talk about DSTs all the time, we’re not going to talk about DSTs today.

Another thing that we talk about is institutional ticks. We talk about installment sales, whether it is in a traditional sense or a structured sale, which is basically an institutional installment sale. But one of the things that really sort of sneaks up when we’re talking and a variety of other topics, but we’re going to talk about installment sales for a few minutes and in one product in particular. In installment sales, one thing that really you’re old enough to know, remember that book, Robert Allen “Nothing Down”?

Robert Smith: Oh, yeah.

David Moore: Okay. So, CC helped me, I was at a conference The Northwest Action Summit. It was a real estate conference, it was what a month ago, CC? They asked me to speak. And so, somebody spoke there earlier that day, was talking about doing all these nothing down deals. And I go, “Oh, yeah, sure, fine.” You know that book I read that in the ’70s, and it is a great book at the time. But have you ever been involved with a nothing down deal?

Robert Smith: No.

David Moore: Okay. So, I have and it’s pretty interesting. We’re sitting around a closing table and all of a sudden the seller is realizing that escrow wants to get paid. You’re the broker, you probably want to get paid, I want to get paid. So, if there’s a nothing down deal, who’s paying us all? And then on top of that, what people don’t understand with installment sales is if it’s an improved property with debt, you’ve got tax on debt relief and depreciation recapture in the year disposition. So, if some broker or somebody comes in and says, “Hey, I want to do a nothing down deal.”

And you think it’s this great idea, you better think twice. Okay? You better understand if you do this installment sale, what you’re going to need to close the transaction and what the tax consequence might be if you do that installment sale. So, anytime we’re looking at an installment sale I’m not… And I’m not saying don’t do an installment sale. I’m just saying understand the repercussions of taking an installment sale and an installment sale could be a wonderful thing. I mean, if you’re looking at selling and carrying a note or a land sale contract today, and you’re saying, well, gee, the guy is going to pay me 7%, you’re thinking, well, where else am I going to get seven?

David Moore: I might not have a good answer for you. It’s pretty attractive if you think maybe. Or if you’re selling to somebody in the weed world, maybe you’re getting 20, right? I mean, it’s possible. So, there are definitely situations where an installment sale is a very attractive thing for a seller. But you better understand whether you’re going to have any tax liability and what it’s going to cost you to get the deal closed.

So, and the biggest problem with an installment sale typically is the buyer might default, or there might be an acceleration that happens. Somebody pays the contractor a note and trust deed off much earlier than you thought. So, if you’re selling and you want to carry paper with the intent of taking income over time, you better have some teeth in that thing, some prepayment penalty, something there that is going to keep things intact. One of the things I like about a note and trust deed, for example, if you’re a good borrower, a good buyer, and I as the seller to you like that income stream, and I don’t want to have the acceleration of payment, at least with a note and trust deed, I can do an assignment of collateral and take care of that.

But the reason I’m giving this sort of long-winded introduction is that there’s something else called an UpREIT. And in my mind, I think the UpREIT is the ultimate installment sale. And I say that for a couple of reasons; One, you don’t have a buyer that’s going to default number two, you’re doing an Exchange into an asset. So, you’re not looking at that tax consequence of debt relief and depreciation recapture during that transaction. And three, I mean, you literally take the tax consequence as you choose to take it. So, Bob, what can you tell the audience about an UpREIT?

Robert Smith: 721 UpREITs have been part of the 1031 Exchange space for quite some time. A very frequently asked question on the part of investors to you, to us historically has been, can I 1031 Exchange into a REIT real estate investment trust? And the answer has always been no, because to have a clean Exchange or good Exchange, there’s got to be direct ownership of dirt… For direct ownership of dirt. And when you’re buying shares of a REIT, you’re doing just that. You’re buying shares of a company that in turn owns the dirt. And it’s that intermediation that has historically disqualified 1031 exchanging directly into a REIT. So, you can’t access REITs directly, but you can indirectly via a 721 UpREIT. And it’s a two step process that first you come in and you do a 1031 Exchange with David into a property…

David Moore: Thank you, Bob.

Robert Smith: Or properties that are specifically tied to the UpREIT, okay? And then depending on the structure of the UpREIT, you will be in that property or properties for anywhere from three to five years until the UpREIT then absorbs or rolls that property in to the REIT itself, doing a 721 Exchange, which is also a tax free Exchange or event. And at that time, your interest in that property will be Exchanged for operating units of the REIT. Okay? And so, you go from owning part or one property to owning bits and pieces of many properties. So, it increases… Depending on the size of the REIT, obviously it increases your diversification, hence safety. And then you sit there with those operating units until such time as you want to stage a liquidity event, and then those operating units, however many you will like not necessarily all of them, whatever amount you choose, are Exchanged for shares of the REIT, and then the shares of the REIT are sold, usually back to REIT management because it’s usually privately held.

And that cashes you out, creates a liquidity event, and in turn, catalyzes a capital gains tax event. It’s important to understand that you never want to convert any more operating units to shares than necessary because you don’t want to catalyze a bigger tax event than necessary. So, you keep as many operating units as you can in that REIT. And if you still have it, because as David mentioned earlier, it’s an end game for a lot of people because you can’t 1031 Exchange out of the UpREIT.

So, it’s most often used by older people who are no longer interested in doing another or subsequent 1031 Exchange and just want to exercise more control over their liquidity event. So, that if you have it… Still have the REIT at the time of your passing, then your heirs will receive the operating units in that REIT on a stepped up cost basis and should be able to then cash out with little or no capital gains tax obligation because most of that or that has passed with you. Is that making sense partner?

David Moore: So, keep an eye on the stepped up basis because our current administration has gone after it and who knows what they’ll go after next. But yeah, I just love that product because I just… People, when do you pay the tax? When do you choose to pay the tax? And when we’re looking at 1031 Exchange, people say, “Well, it’s a tax free Exchange.” It’s not tax free, it’s tax deferred. So, one of the biggest objections people have going into a DST historically has been that hold period, right? You’re locked into it.

And then if imagine you do pass away your heirs receive it, they’re still going to go for that ride where the UpREIT is a situation where you literally choose to sell those shares when you choose to sell them and pay the taxes, you choose to pay it. And so, you made a lot of money last year, you didn’t want to sell any. This year, maybe you get crunched a little bit, maybe you decide to do it, offset the losses with the gains, boom, boom, boom. But I just think it’s the ultimate installment sales.

Robert Smith: It is. And it’s very convenient that way. The one thing I would encourage anyone considering the UpREIT option to do, is you have to remember that any REIT real estate investment trust is only as good as the properties in it. Okay? And for better or worse, most 721 UpREITs currently in the marketplace tend to be pretty narrow in their asset focus. Meaning they will focus on acquisition of a single property type, whether it’s industrial warehousing, retail properties, what have you. And we’ve always felt that the more option… You as a real estate investor, the more options you can have and maintain, ultimately the better served you are going to be.

And so, what might be topical today from a property type might not be topical tomorrow. And so, I would encourage people when considering the UpREIT option to focus, singularly focus on the composition of that REIT, in terms of property types and how that property type has done historically, what the current market environment for that property is, and what the future may bring for that property. And I think the more diversified you are, as long as it’s thematic, you don’t want just a little bit of this and a little bit of that and then you really get nothing, as long as the diversification inside the REIT is thematic based on current market conditions, you’re probably well served. But I would encourage you… I would encourage people to look for diversification from a property type standpoint inside an UpREIT as opposed to specialization.

David Moore: And as always, the sponsors involved.

Robert Smith: Yes.

David Moore: I really, I want to stress, once again, we’re talking mid-June of 2022, and there’s a lot of stuff going on needless to say, and I would encourage anybody that’s looking at any type of passive investment, really look at the sponsors you’re working with. You want to be working with Companies who have been through the dark times, not with somebody that’s never seen a bad time. So, keep that in mind wherever you go. Don’t chase the yield necessarily, look at something and the stability over time. You want to make sure, what good is a tax deferral if the replacement goes away? And that’s a little bit my concern.

People ask a lot about opportunity zones and just leave… We will sort of sign off talking briefly about OZs, but OZs, I think they’re a great play if you’re giving up personal property, wanting to go into real estate, if you’re giving up a business, you want to go into real estate, I really don’t care for them as a real estate to real estate play. And no matter what you are buying into a development. So, do you really want to be going into a development today?

Robert Smith: Well, you’re exactly right because with any opportunity zone, unlike a DST or an UpREIT which is populated by stabilized cash flowing properties, they’re almost always development programs, meaning they’re tearing something down or building something up or redeveloping. So, you’re assuming development risk, one. Two, they’re usually not going to cash flow initially or for a period of time during that development.

And I think most significantly, because it is a development play and it’s supposed to add value, but when opportunity zones were created by Congress and all these different governments lobbied aggressively to have areas designated opportunity zones. If you don’t think land speculators were already there trying to leverage up on the future value that that would represent, as soon as it becomes… As soon as it’s designated an opportunity zone, then as my dear departed mother used to say, “A fool and his money are soon parted.” Because it has already been revalued upward. So, the question is, is your developer or is your development good enough to continue that process?

David Moore: Definitely.

Robert Smith: So, something to think about.

David Moore: So, for some reason, George Bush came to mind, but during an UpREIT, good OZ, I won’t say. Anyway, thank you for your time today. I really appreciate it. David Moore with Equity Advantage, 1031Exchange.com. And I, once again was blessed to have Robert Smith of Peregrine Private Capital, and it’s always good to have you here, Bob. Thank you.

Robert Smith: David it’s always good to be here, buddy. Thank you.

David Moore: And as always, please don’t hesitate to reach out and if you’ve got some topic you’d like to hear more about, let us know. And please like and subscribe. We love getting this content to you and we hope you find it helpful. Thank you, and best all, take care. Bye.