A Tale of 2 Investors

Grayson and Wayne are partners at Tricorner Yards, a multi-use real estate development project. The two amassed a sizable tract of waterfront property in the Tri-Corner area and successfully rehabilitated and developed what were once rundown shipping yards into a bustling urban center. With their work complete and the properties fully leased or sold, Wayne and Grayson want to move onto the next chapter in their lives; and so, begins the tale of tax-deferred exchanges.

Wayne's Umbrella Partnership Real Estate Investment Trust (UPREIT)

Wayne is at the point in his life when he would like to be able to move away from daily management and begin enjoying the fruits of his labor. His children have not expressed any interest in taking over the family real estate empire, so he's willing to give up the property. However, Wayne is not interested in a traditional sale. He does not want capital gains taxes to diminish his investment in the next deal. Given these facts, his tax advisor presents a solution with the potential to address both of Wayne's concerns.

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The advisor recommends that Wayne contribute part of his interest in Tricorner Yards real property, specifically the institutional grade property, to an UPREIT in exchange for securities known as operating partnership (OP) units or limited partnership (LP) units with a value equal to the contributed property.

Relying on the partnership rules, the exchange is designed to be a non-taxable transfer. Tax should not be due until Wayne exchanges his OP units for real estate investment trust (REIT) shares or cash. However, if the OP units are held at death and receive a step-up in basis, the built-in gain could be wiped out altogether - at least up to the date of death value of the OP units.

With this strategy, Wayne does give up control and could also be subject to an unplanned tax bill if the REIT were to sell the Tricorner properties. But Wayne assumes - and is comfortable with -- this risk in exchange for the diversification, economy of scale and management offered by the REIT.

Grayson's S. 1031 Exchange

Grayson is a bird of another feather. He intends to remain actively involved in the development business and has already identified his next project. He too has good tax counsel, who has suggested an S. 1031 exchange in order to maximize the cash available to roll into the new deal.

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An S. 1031 deferred exchange requires Grayson to meet a specific timeline, beginning on the date he sells the Tricorner properties, or he'll face immediate income taxes on the sale. However, Grayson does not want to wait until his current Tricorner properties are sold before purchasing his next property. He has already identified a fantastic opportunity with a highly motivated seller and does not want another buyer to swoop in and steal it from him. Luckily, the S. 1031 exchange can be done in reverse.

The reverse exchange allows Grayson to designate a qualified intermediary, who takes title to Grayson's new property after the purchase and parks it until the sale of his Tricorner properties closes. If successful, Grayson's reverse exchange should preclude recognition of capital gains.

Holy tax-deferred exchanges.

While our real estate dynamic duo is fictional, their tales have real-life applications for the following types of people.

• Real estate investors, who wish to diversify their holdings without paying an exit tax;
• Real estate owners, who are ready to move out of the daily management of properties; and
• Owners or investors looking for the next project and not an immediate tax bill.

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Both Wayne and Grayson were able to use specific sections of the tax code to avoid the immediate recognition of income on the sale or exchange of their Tricorner properties, but we should emphasize that these strategies ultimately lead to the same ending. Eventually, Grayson and Wayne - or their heirs -- can count on a tax bill.

If the cape fits...

How do you determine which exchange is ideal for your situation? Consider the following questions when working in conjunction with tax and legal counsel.

• Do I, or does a member of the family, wish to continue daily management activities?
• Am I comfortable giving up control?
• Will this be my last exchange or just one in a series of exchanges as I move from one project to the next?

While not an exhaustive list, these should provide clues as to which path to consider - UPREIT, S. 1031 exchange or reverse S. 1031 exchange. And while deferral can be an important tool, you should carefully weigh the tax benefits of the transaction against the long-term strategic plans for your assets and your family.