Does a 721 UpREIT Help Me With Liquidity

Wally Smith:
Well, to that point, let’s talk about the advent of the 721, the UPREIT, how that works. That’s really recognized now as being the answer for the liquidity solution, but whether it’s compulsory or not, whether it’s an option. I know some of the sponsors require it, but let’s go back, tell me about 721s.

Jeff Hertz:
721 has been around for several decades, quite simplistically it is a related part of the tax code. It’s different than 1031, but it has similar attributes. So in a 721 exchange, I may own a piece of real estate. I’m looking to sell it. I’m approached by a large institution, let’s say it’s a real estate investment trust, and it would be better for them from a cash management standpoint to acquire my property without having to pay me cash. And it may be better for me from a tax planning standpoint to not have to do a 1031 exchange. So the old school original version of a 721 is I transfer my ownership of that property to that REIT in exchange for equity in that REIT, which is a non-taxable event and-

Wally Smith:
Non-tradable.

Jeff Hertz:
Well, it could be traded or it could be non-traded.

Wally Smith:
Okay. But for it to be at a tax free thing, it has to be on the non-publicly traded side. Correct?

Jeff Hertz:
It would be-

Wally Smith:
Operating partnership.

Jeff Hertz:
It would be operating partnership units. It could be in a publicly traded REIT. I could sell my warehouse for lodges and they could give me equity in that REIT if that’s an option that’s available for them. But we definitely see it more in the non-public REIT space.

Wally Smith:
So instead of Ma and Pa Kettle selling the family farm and putting that directly into an Amazon warehouse or something like that, they would actually take that. And it’s probably a bad example using a family farm. You don’t have that many REITs.

Jeff Hertz:
Well, it’s a good example in terms of where I was leading with that.

Wally Smith:
Sure, sure, sure. But being able to take the, maybe the doctor has an apartment building and now he doesn’t want the apartment building, it fits into a real estate portfolio of a large sponsor, and they say, well, that would fit right in with what we do. So now they exchange that. That’s not a taxable event at that point.

Jeff Hertz:
Correct. Correct. Then I guess the challenge is then you end up owning that REIT for an extended period of time. Maybe you do some selling sporadically and so forth.

Wally Smith:
The nice thing about it is, let’s say it’s a $20 million apartment building that’s fully depreciated. Instead of having this huge capital gain, now once it’s in the REIT, after it’s been in there for I guess a year, you can start to dribble it out, maybe take a couple hundred thousand dollars a year of liquidity out of it at a much lower tax rate.

Jeff Hertz:
So then the more recent version of the 721 exchange, what some referred to as the two-step transaction relates to the fact of exactly what you were saying. If I own farmland in Iowa and who’s going to buy that from me? It’s not going to be a large institutional REIT, because there aren’t that many that specialize in farmland. If I own a duplex here in Denver, same thing. I’m not going to sell it to any large institution. So the two step 721 allows an investor to cash out of something that is not necessarily desirable by a large institution, do a 1031 exchange into a DST, but that DST has already been predetermined that it is going to be pulled up into a larger REIT, a larger diversified REIT vis-a-vis that 721 transaction.

Wally Smith:
That would’ve to be generally after two years.

Jeff Hertz:
Correct.

Wally Smith:
And then another year hold before you could then the taxable events when you take the non-publicly traded operating partnership units and move them over to the publicly traded side to liquidate them and sell them.

Jeff Hertz:
Exactly. Exactly. And there’s a lot of scenarios that that works for. One, just simply diversification, right? If I take my million dollars and I invest into a single DST that happens to be a single property, I’m no more diversified than I was to begin with, right? So knowing that that DST is going to be pulled up into a multi-billion dollar REIT, I know that I’m going to be much more diversified down the road. It eliminates the need to do future 1031 exchanges, which can be attractive or not attractive.

Wally Smith:
How does the step-up in basis work on that whole process?

Jeff Hertz:
They effectively would maintain their same cost basis by going into the REIT. The nice thing, if there is any nice thing about passing away is when you pass away you have an immediate day of death valuation based on what the shares in that REIT are worth at that time, whether they’re valued on a daily, monthly, or annual basis.

Wally Smith:
Now it’ll depend on each REIT, but now the due diligence, instead of looking at doing a 1031 into a DST and having to have the due diligence on that DST itself, the sponsor, the property and everything, now you’re really looking at being in bed with that REIT. And so you are generally going to want to have a very robust, strong, big REIT that’s been around a while, that’s very diversified, got a great track record.

Jeff Hertz:
At the end of the day you’re in that DST as a launchpad to being in a larger entity generally no more, well, I shouldn’t say no more than two years, but at least two years. But in terms of how long you’re going to be in each phase of that transition, you’re going to be in that individual DST a lot shorter time than you’re probably going to end up being in that REIT. So you probably want to focus your due diligence more on the sponsor and the REIT itself.

Wally Smith:
Well, with the aging baby boomers, we’ve got several clients who are very thoughtful and I don’t know, they’re aware that they’re not on the top of their game, and they’re saying, well, I think I’m processing everything right now, but I know I really had to study this. I don’t know how I’m going to be processing and thinking where my cognitive abilities are going to be in five or 10 or 15 or 20 years. And so really knowing that they’ve got something that is going to be understandable, something that their heirs can work with and not burdening their, that’s one of the things we run into is people saying, I found this, I understand it, but my kids will never be able to figure this out, or my spouse will never be able to. I think that’s one area where, and not to mention names, but there’s some very big strong storied companies that have some wonderful strong REITs, right?

Jeff Hertz:
Absolutely. There are portfolios that people would put money into irregardless of the tax advantages. It just happens that they get that tax deferral. But no, to your point, I met with an investor years ago who owns something like 25 individual properties in a certain market. He loved, he had a property management company that he worked with who managed all the assets. And his primary concern was, if I go first, whether it was his wife or his kids were going to have to deal with it, and they just were not involved in that management. So he was looking at it from a transition in the state planning standpoint, which is-

Wally Smith:
Well, it’s so wise too.

Jeff Hertz:
Exactly.

Wally Smith:
It’s not controlling from beyond the grave, but it’s just understanding that maybe, again, it’s a baby boomer thing, but the idea of I’ve been a provider, and not just providing materially, but providing guidance, providing the options. And what I like to say, whenever you have more than one kid in a family, parents will tell you, they’ll say, this kid is this, this kid’s that. Right? And we work with attorneys on estate planning and that thing, and living wills. There’s one kid that’ll say, dad’s going to be a fighter, he’s going to hang in there, keep him on the machines. And the other one said, no, dad said seven days and let’s pull the plug. But there’s always some kids who are going to be able to handle inheritance better, be able to be better stewards of it and protect it. It’s a great tool, the 721, using a REIT and being able to leverage their way into that.