Understanding DST-to-UPREIT transactions

How can an investor keep a high-performing Capital Square multifamily DST investment at the end of its lifecycle, while gaining additional benefits? Our newest expertise piece has this answer and more:

Video highlights include:

• Introduction to 721 Exchanges (jump to 0:39)
• Can an investor keep a DST for the long term? (jump to 1:27)
• What is Capital Square Housing Trust? (jump to 2:11)
• Can an investor invest in a REIT for the long term? (jump to 2:50)
• What are the benefits of an UPREIT? (jump to 3:11)
• Why should interest rates be considered when deciding whether to UPREIT? (jump to 6:47)
• How does Capital Square handle UPREITs differently? (jump to 7:39)
• A recap of DST-to-UPREIT considerations (jump to 8:17)

Approximate transcript

Hello, everyone. I’m Louis Rogers, founder and co-CEO of Capital Square.

Capital Square is the sponsor of tax advantaged real estate programs. We have a very broad range of tax-advantaged real estate programs. You may know us for our Delaware statutory trusts. Those are for 1031 exchanges, building family wealth. It’s a very powerful tool. Also, opportunity zones, where you can defer and exclude taxes. We also have development funds and a real estate investment trust that invests in the same type of properties as the DSTs.

You’re used to hearing about Section 1031, deferring tax. There’s a similar provision called Section 721: when you contribute property to a partnership, you have no tax going in; your tax basis carries over; and you retain all the benefits of an owner. So when we’re talking about contributing your DST interest to the UPREIT, we’re under section 721. There’s no tax, federal or state, and you retain the benefits of ownership, so you continue to depreciate the property.

You’ll remember that depreciation shelters your cash flow, which gives you a higher return. Those that invest in stocks and bonds don’t get depreciation, and you get the benefit of depreciation, even though your property appreciates. Isn’t that a wonderful thing? Congress really loves real estate.

Lots of our exchangers say, “I’m really happy with my building. I would like to keep my building forever. Can I do that?” And the answer under the DST structure is that you cannot. At the end of the holding period, the building is sold. You can do another exchange and another and another and another. You can exchange over and over again as long as you want, and if you die holding the property, you will get the step up in basis and tax forgiveness.

They say, “Is there a better way? I really like my building. Can I keep my building?” And the answer is yes. You can keep your building by contributing it to the UPREIT.

You say, “UPREIT? I don’t even know what a REIT is, much less an UPREIT.”

Well, let’s take some time with this. Capital Square is the sponsor and advisor of Capital Square Housing Trust. It’s a real estate investment trust. It’s built for stable income and growth.

The way REITs are formed, all of their real estate is in an operating partnership, a great big partnership, and it’s on top in the org chart, so it’s up and the REIT is on the bottom, so it’s an Up-REIT, simply put. And the beauty of the UPREIT transaction is the exchangers can keep their property – obtaining many, many benefits – and never have to exchange over and over again.

To some people, doing another exchange is a real hassle. It stresses them out: 45 and 180 days and all that jazz from 1031 land can be a real hassle for people. But by going into the UPREIT, you can park. You can have tax deferral, and you can stay there for the rest of your life with tax forgiveness.

And you say, “Well, UPREIT. Okay. What are the benefits?”

Let me go through some of them.

1. I’m a tax lawyer, so the one I like the best is permanent tax deferral. You can park in the REIT and defer your tax from your relinquished property, and for many relinquished properties. If you’re a serial exchanger and you’ve exchanged over and over and over again, you can defer all of that tax by UPREITing and parking in the operating partnership: permanent tax deferral, federal and state, every state.
2. Increased cash distributions. Who doesn’t appreciate more cash in their pocket? If your distributions go up 24% in one case, 52% in another case, what’s not to like about that?
3. Diversification. That’s a really big one. Most DSTs are single asset. Those assets are not diversified by definition. They are concentrated. By UPREITing, you now own a piece of a number of properties, a large portfolio, many properties, many residents, many sub-markets. It’s much safer; it’s much more diversified, and it’s much better for most investors.
4. You continue your tax benefits. Lots of the investors say to me, “I really like owning real estate because of the tax benefits,” right? I’m allowed a deduction for depreciation. You say, “well, it’s funny because my property appreciates, but Congress gives me a deduction for depreciation.” That means the after-tax return from real estate is higher. You keep all of those benefits, all of the continued tax benefits of real estate ownership.
5. The REIT is able to improve the property you’ve contributed. In the DST structure, we’re very limited in how much we can do in improving a property. In the REIT structure, we’re not limited at all, and we have cash to improve properties.
6. Transparency. We have a board of independent directors under the New York Stock Exchange rules. I’m a director, but my vote doesn’t count. Only the independent directors vote, and they make the important decisions for the REIT.
7. And finally, potential future liquidity. You have the right to exchange your operating partnership (OP) units for REIT stock someday, when the REIT is listed and the shares trade. You’ll have liquidity any day you want by swapping your OP for REIT stock and selling on the New York Stock Exchange.

The DST is a short-term hold. You have to sell when the loan matures under our tax rules, but in the REIT, in the UPREIT, we can hold these properties forever.

The REIT has a lot of property, economies of scale. It has big pool of property, and so the fees are dramatically lower in the REIT model. All of those factors mean that the UPREIT is an excellent solution for many people.

As people get older, they get tired of playing the game, and in the REIT they can park forever.

Our mission is to is to provide tax deferral, initially under Section 1031, but by contributing your DST property to the REIT, you can park and have tax deferral forever. One of the challenges today in exchanging is 1031 requires you to have equal or greater debt, but interest rates today are dramatically higher.

When we do the UPREIT transactions, we typically assume the existing loans. We have lots of loans that are 2% and 3%. We have some that are 4%. We’re assuming those. We’re keeping the benefit of those. You may choose to do another 1031 exchange, and we’re happy for you to do another 1031 exchange – with Capital Square, please – but keep in mind the interest rate today might be 5.5% or 6% compared to 3%, 4.5% on your old property that’s being UPREITed.

So, one of the benefits is to keep the benefit of the low interest rate mortgages from days past, but really it’s a personal decision.

Other sponsors are mandatory. They force you into the REIT, and we don’t think that’s appropriate. We think you, the investor, with the assistance of your financial advisor, should decide what’s best for you.

I’m Louis Rogers, founder and co-CEO of Capital Square. We love our DSTs. We love our one big, beautiful building that we’re in today, Tapestry West Apartments, here in Richmond, Virginia. Most of Capital Square’s investors like the UPREIT because it’s permanent. It gives you permanent tax deferral, but if you like to exchange, that’s great. We’re in the exchange business. We’ll find you a big beautiful 1031 DST to make you happy.

You’ve invested in the property; you’ve held it for a few years; it’s matured. The time comes to sell, and you’re offered an UPREIT option. In all events, you get your share of the sales price, your investment, your appreciation:

• in OP units if you choose to go into the REIT,
• in cash to your QI if you choose to do an exchange, or
• in cash to your pocket if you’re an heir, and you’ve received the step up in basis.

Many benefits in the REIT. For most investors, the REIT is the way to go, but we believe that you should make that decision on your own.

In my experience, older investors prefer the REIT because they can park for the rest of their lives with tax deferral forever.

You can exchange again and exchange again and exchange again, and you’re on the treadmill of 1031, and that’s great. That’s how we make our living. But if you want to get off that treadmill, you can go from your DST into the operating partnership of the REIT, we call the UPREIT, and park there forever.

Many benefits, bottom line: you choose. You’re the owner. Make the decision that’s best for you. Thanks, everyone.

Essential takeaways:

The investors-first promise of UPREITs into Capital Square Housing Trust means:

• Our investors are never forced into an UPREIT when their DST property reaches maturity, and
• Only strategic, high-performing properties from our DST portfolio are destined for the REIT.

The 1031 to 721 Investor Journey can seem complicated, but at Capital Square, we know education allows for tremendous opportunities.

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Disclosure: Securities offered through WealthForge Securities, LLC, Member FINRA/SIPC. Capital Square and WealthForge Securities, LLC are separate entities. There are material risks associated with investing in DST properties and real estate securities including illiquidity, tenant vacancies, general market conditions and competition, lack of operating history, interest rate risks, the risk of new supply coming to market and softening rental rates, general risks of owning/operating commercial and multifamily properties, short-term leases associated with multifamily properties, financing risks, potential adverse tax consequences, general economic risks, development risks, long hold periods, and potential loss of the entire investment principal. Past performance is not a guarantee of future results. Potential cash flow, returns and appreciation are not guaranteed. IRC Section 1031 is a complex tax concept; consult your legal or tax professional regarding the specifics of your particular situation. This is not a solicitation or an offer to see any securities. Please read the Private Placement Memorandum (PPM) in its entirety, paying careful attention to the risk section prior to investing. Diversification does not guarantee profits or protect against losses. Private placements are speculative.