As a brief background, in a traditional REIT structure, the trust owns property directly or through limited partnerships. However, suppose an investor contributes real property to a REIT. In that case, the investor must recognize any increase in the value (fair market value over tax basis) that has occurred and would owe taxes on that amount. In an UPREIT (an Umbrella Partnership Real Estate Investment Trust), the umbrella partnership (aka operating partnership) manages the assets and indirectly owns them through the REIT.
The investor contributes the property to the Umbrella partnership through an IRS sanctioned 721 exchange for Operating Partnership Units instead of REIT shares. This process allows the taxpayer to defer the gain until they convert the OP Units to shares (or until some other triggering event occurs in the UPREIT organization).
What place does debt play in the transaction?
Suppose that the investor (in this case, the contributor of real property) contributes an asset to the partnership, and with it, the UPREIT takes on an unqualified liability. In that case, the transfer would be considered to include money or other consideration and potentially subject to the disguised sale rules. The debt must be a qualified liability to be excluded.
A qualified liability includes the following:
- It was incurred more than two years before the contributor transferred it to the partnership and has been attached to the property for the two years, or
- It was incurred within two years but not in anticipation of the contribution of the property, or
- It can be allocated to capital expenditures made for the property, or
- It is related to the business taking place on the property, and the business assets are also transferred.
Mortgage debt is often a qualified liability, but not always.
If the property has mortgage debt in place for at least two years (like the above rules on other liabilities), it will usually be recognized as qualified. If the mortgage debt is newer than that, the determination will depend on how the borrower used the funds. Money borrowed for improvements may well be designated as qualified, but other purposes may result in a finding of unqualified liability.
What is Section 752?
After the successful settlement of the transaction with the application of the disguised sale rules, there is another debt related issue to consider. Suppose that the investor contributes assets with liabilities that exceed their tax basis. That taxpayer must ensure that they receive an allocation of debt within the Operating Partnership of an amount adequate to offset the excess. In other words, if the contributor ends up with less debt following the transaction, that would be considered a gain, and that would trigger a taxable event. The investor needs to receive a liability allocation to shield his interests from that occurrence.
Protecting the contributor from future debt reduction exposure
Since maintenance of adequate debt levels is vital for the investor to avoid inadvertent exposure to a gain and accompanying taxable event, the subject is usually included in the Tax Protection Agreement portion of the UPREIT transaction. The TPA commonly requires the Operating Partnership to reimburse the contributor for costs incurred if it sells the asset (triggering a gain), but it may also require the partnership to be responsible for maintaining a level of liabilities to cover the contributor's negative tax basis and allocate them under nonrecourse rules.