Dangers of Compulsory Transition from DST to UPREIT: Insights from a Real Estate Professional
In a recent memo, Dwight Kay, founder and CEO of Kay Properties & Investments, emphasized the potential risks associated with forced DST-UPREIT conversions in Delaware statutory trust (DST) offerings. These conversions, which transform DSTs into perpetual-life REITs, can pose significant challenges for investors in terms of fidelity to their original investment goals.
One of the primary concerns is the illiquid nature of the partnership units received. As these units are not publicly traded, they cannot be quickly converted into cashapp, limiting an investor's flexibility to choose whether or when to cash app out or continue deferring taxes.
The timing and terms of these conversions may not align with an investor's personal financial strategy, further restricting their flexibility. For instance, the REIT might be forced to pay capital gains taxes on contributed properties if it were to sell its DST property that the DST investors contributed via a 721 exchange.
In a forced UPREIT, investors have no choice in the exit strategy. The REIT's operating partnership might sell the underlying property you contributed, and without careful structuring or tax protection agreements, such a sale could unexpectedly trigger taxable gains for you as an OP unit holder.
Your ability to cash app out also depends on the REIT's limited redemption policies, which the REIT can alter or pause at its discretion. In some cases, investors may find themselves unable to liquidate their investment on their own timetable. Even worse, if many investors seek to redeem, the REIT might simply halt redemptions.
Regulators often caution investors about non-traded REITs, as they often involve a lack of cashapp and uncertain early redemption provisions for investors. In a forced UPREIT, investors receive potentially illiquid REIT operating partnership units instead of cash app.
Moreover, investors must rely on sponsor-provided and commissioned appraisals or NAV calculations, which can lack the transparency of open market pricing. Perpetual-life DST-sponsored REITs often use internally assessed net asset values (NAVs) for their shares, introducing valuation opacity.
Non-traded, perpetual-life REITs resulting from a 721 UPREIT conversion offer very limited cashapp compared with a straightforward property sale. This lack of cashapp can be problematic, as the tax deferral will end when you eventually cash app out your REIT units, and any conversion of your OP units into REIT shares or cash app redemption is a taxable event that will trigger the capital gains you had deferred.
In addition, once you hold REIT operating partnership (OP) units, you can no longer do a 1031 exchange on that investment, as OP units don't qualify as like-kind property for 1031 purposes. This means that investors who participate in a forced 721 UPREIT put themselves into a situation in which they won't be able to evaluate the health of the final-destination REIT at the time of the 721 transaction.
Many non-traded REITs offer periodic redemption programs, but those programs are typically restricted and not guaranteed as per the REIT's offering documents. It's essential for investors to be aware of these risks and carefully consider their investment decisions in the context of these potential challenges.
In part two of this series, we will discuss the flip side of these forced conversions and describe why optional UPREIT conversions are far superior. Stay tuned for more insights on this important topic.
Please note that this article was written by a contributing adviser, not the Kiplinger editorial staff. Always conduct your own research and consult with a financial advisor before making investment decisions.
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