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A Historical Perspective: The Progression & Institutionalization of Tax-Advantaged Real Estate

Aerial view of suburban neighborhood when the leaves are starting to change colors

**This article first appeared as a section of the article Capital Square’s founder and co-CEO, Louis Rogers, wrote for the DI Wire, titled “A Deeper Dive: DST to UPREIT: Unlocking Greater Value & Optionality for Investors” and published May 2, 2023.**

Back in the day, a “whole property,” frequently a rental house, was the typical 1031 replacement property. It is hard to imagine a less institutional property than a rental house managed by the taxpayer.

Then, starting in the late 1990s, the tenant-in-common (TIC) industry developed to provide fractionalized, institutional-quality real estate to regular folks, but many TIC investments became challenged during the great real estate recession starting in 2008. Since 2012, the Delaware statutory trust (DST) structure has worked exceptionally well. The major sponsors use the DST structure, and the many successes are reported daily in The DI Wire.

Back in the ’80s, the goal for corporate and tax lawyers was to combine two critical attributes in a single investment vehicle – limited liability, like you would have in a corporation, with pass-through (one-level) taxation that you would have in a tax partnership. Back then, this was accomplished in a very cumbersome way by using a limited partnership with a corporate general partner. The analysis was so complicated that tax opinions were needed, at substantial cost, just to verify the structure. That was a very long time ago.

Beginning in the early ’90s, Virginia and other states began to adopt a more modern form of entity; the limited liability company, or LLC, was born. By combining the attributes of limited liability and pass through (partnership) taxation in a single entity, the LLC became the entity of choice for real estate ownership. No more complicated structures or expensive tax opinions were needed. That was phase one in the evolution of tax-advantaged real estate.

Next, in the 1990s, non-traded real estate investment trusts (REITs) became a popular vehicle for aggregating real estate assets in a tax-efficient manner. While REITs are taxed as a corporation, they have the benefit of using depreciation deductions to shelter dividends on the REIT’s stock, creating, in essence, one level of tax on earnings, and REITs have large portfolios of real estate for greater diversification. Non-traded REITs were sold by many independent broker-dealers nationwide, making them mainstream.

About the same time, the tenant-in-common (TIC) industry was born, with the goal of creating a structure for individual investors to exchange into a portion of an institutional-quality property as their 1031 replacement property. From humble beginnings, the TIC industry took off and was commercialized when the IRS issued the famous Revenue Procedure 2002-22 and CMBS lenders approved the structure for non-recourse lending. That was the second phase in the evolution of tax-advantaged real estate.

The third phase developed after the great real estate recession of 2008 decimated much of the real estate industry. The TIC structure worked well to create a tax structure that qualified for 1031 treatment. But the TIC structure was cumbersome and inefficient from an operational standpoint. The stress of the great recession caused many investments to fail, and foreclosures were common, especially suburban office properties.

Back in 2004, the IRS issued Revenue Ruling 2004-86 on the use of a Delaware statutory trust (DST) as another vehicle for 1031 exchanges. The revenue ruling imposes several strict requirements for a DST to qualify as a fixed investment trust in which the beneficial interests in the DST are “like kind” to real estate. The DST structure is a major improvement over the TIC structure from an operational standpoint. The TIC structure was disfavored following the great recession, and the DST structure became the preferred choice starting around 2012. And the DST structure has taken off, with billions of dollars of equity raised each year. The results have been phenomenal. The DST era for 1031 exchanges is the third phase in the evolution of tax-advantaged real estate.

Now, we have DST to UPREIT transactions that combine favorable tax treatment with the potential for additional benefits to investors. UPREIT stands for “umbrella partnership real estate investment trust.” However, only certain properties are candidates for UPREIT transactions, and the target property must satisfy the REIT’s buy-box. Over time, you are likely to see more DST to UPREIT transactions being offered to DST investors after a safe harbor holding period, typically two years. Each investor should decide, with guidance from their financial and tax advisors, what is in their best interests. In the right circumstances, UPREIT transactions can be a valuable tool for financial planners and investors seeking a turn-key, investment grade replacement property solution. 

The industry should remain open to new structures, so long as they provide full optionality and equality for all investors. This is not a one-size-fits all investment; each investor should make their own determination of what is best for them (and their family and estate). It is gratifying that the REIT and DST structures have been stress tested and proven to be solid, even during periods of economic turmoil. Having more investment options is a nice benefit for investors and their advisors. 

DST to UPREIT transactions are the next phase in the progression and institutionalization of tax-advantaged real estate.

Over time, we will see further evolution of tax-advantaged real estate investments. Of the various legal structures used over the past 40 years, the DST structure has proven to be the best for taxpayers seeking tax deferral under Section 1031. For the past decade, DST sponsors have done a superb job of providing tax deferral along with stable returns and capital appreciation. Even during the COVID pandemic and economic challenges, the DST structure, with strong sponsors of institutional-quality real estate, has proven to work exceptionally well. The DST structure has been stress-tested and has proven to succeed even in the face of challenges.

This is an exciting time to be in the real estate business.

Louis Rogers, the founder and co-CEO of Capital Square, one of the leading sponsors of 1031 exchanges and other tax-advantaged real estate investment programs, is an acknowledged expert on the legal history and application of Internal Revenue Code Section 1031.


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