How Taxpayers Can Use an UPREIT for Estate Planning and Valuation Discounts

Using an UPREIT (Umbrella Partnership Real Estate Investment Trust) can be a strategic way for taxpayers to leverage estate planning valuation discounts while potentially sidestepping some of the challenges currently arising in the courts. In recent years, courts have increasingly scrutinized valuation discounts applied to family-owned businesses and limited partnerships, often resulting in taxpayers receiving reduced discounts or, in some cases, no discount at all.

Read on to see how to successfully implement UPREIT strategies using discounting in your estate plans.

Understanding UPREITs and Their Advantages for Estate Planning

An UPREIT allows property owners to contribute real estate assets to a partnership in exchange for partnership units rather than cash. These units can be converted into REIT shares after a specified holding period, allowing the taxpayer to diversify holdings and gain liquidity without triggering immediate capital gains tax. Importantly, the partnership units within the UPREIT are generally considered to be less liquid than publicly traded REIT shares, thus potentially qualifying for valuation discounts based on lack of marketability and control. If the REIT is a non-traded REIT and has limitations on redemptions, this will further back the case for marketability discounts.

The use of UPREITs in estate planning can offer key benefits, including:

1. Valuation Discounts: Because partnership units in an UPREIT are not publicly traded (and oftentimes the REIT shares are not traded either), they may be appraised at a discount due to restricted liquidity. This can reduce the taxable value of an estate. Because the units often lack voting control, i.e. the contributing owner goes from having full control of the properties to being one of many shareholders with limited voting rights.

2. Income Diversification: By converting real estate assets into partnership units and eventually REIT shares, property owners can reduce concentration risk and ensure beneficiaries receive diversified income streams.

3. Estate Liquidity: REIT shares, once converted, provide greater liquidity than direct property ownership. This liquidity can ease the estate administration process and assist in paying estate taxes without the forced sale of real estate assets.

   
   

Valuation Discounts in the Context of UPREITs

1. Lack of Marketability and Control Discounts

UPREIT structures in estate planning can support substantial valuation discounts for both lack of marketability and minority interest, provided the structure includes transfer restrictions and limited control provisions. When a taxpayer contributes property to an UPREIT, they typically exchange direct control of their assets for limited partnership units that offer only restricted liquidity options. For instance, many UPREITs rely on redemption mechanisms, which limit immediate liquidity compared to publicly traded shares. This reliance on a controlled redemption process restricts the transferability of the units, creating genuine marketability limitations.

In addition, the contractual terms of UPREITs often limit voting rights for limited partners, significantly reducing the taxpayer’s control over asset management. Unlike direct property ownership, these units afford little or no say in operational decisions, meeting a key requirement for a minority interest discount. Property-specific limitations, such as mandatory holding periods or conversion restrictions, can further emphasize these limitations on control and marketability, creating a strong basis for a defensible valuation discount.

2. The IRS and Judicial Challenges to Discounts

The IRS has historically scrutinized valuation discounts, particularly those applied to family-controlled entities. Courts have similarly challenged discounts that appear artificially inflated or used primarily for estate tax avoidance. However, UPREIT units often have bona fide restrictions and are widely used in legitimate investment practices, which may make them more defensible under scrutiny. Still, careful structuring and clear documentation of the UPREIT’s business purpose and ownership restrictions are essential to avoid challenges.

3. Case Law and Judicial Trends Impacting UPREIT Discounts

Recent cases such as Kress v. United States and Estate of Michael Morrissette illustrate how the courts have imposed strict requirements for valuation discounts on family-owned assets, particularly where family control and ownership appear to serve primarily tax avoidance purposes. Courts have increasingly looked for clear non-tax motives and operational constraints that justify discounts. The formal structure and regulatory requirements of REITs provide a layer of legitimacy, but it’s crucial that the UPREIT partnership agreements are carefully drafted to include specific transfer restrictions, holding periods, and other terms that affirm the legitimacy of the discounts claimed.

Implementing an UPREIT Structure: Practical Steps for Taxpayers

For taxpayers interested in leveraging an UPREIT for estate planning, here are practical steps to consider:

1. Establish the UPREIT Structure: Converting properties into an UPREIT structure involves forming a partnership in which property owners exchange their real estate for partnership units. These units should be subject to clear restrictions, including limits on transferability and conversion timelines.

2. Document the Business Purpose: Ensure the UPREIT’s business purpose is well-documented, ideally showing how the structure benefits the underlying real estate business, not solely for tax valuation purposes. This could include diversifying investments, expanding real estate holdings, or increasing liquidity options for beneficiaries.

3. Comply with Regulatory Requirements: REITs are subject to specific requirements, such as income and asset tests, which need to be adhered to strictly. Not only does this enhance the legitimacy of the REIT, but it also reduces the risk of the IRS arguing that the structure is solely a tax-avoidance mechanism.

4. Independent Valuation: Engage a qualified independent appraiser with experience in UPREIT structures. They can determine the appropriate discount for lack of marketability or control based on the terms of the partnership units and the overall structure, which strengthens the taxpayer’s position if challenged.

5. Consult Legal and Tax Advisors: Due to the complex nature of UPREITs and the evolving judicial approach to valuation discounts, consulting with both legal and tax professionals is crucial. They can ensure that all documents are prepared accurately and provide defense strategies if the estate valuation is challenged.

   
   

Addressing Recent Court Challenges with Proper UPREIT Structuring

The IRS and courts are particularly wary of valuation discounts that lack economic substance or are not commercially justified. However, the structured and regulated nature of UPREITs offers a unique advantage in this context. Here’s how a well-structured UPREIT can address recent legal challenges. A good UPREIT can help you document this by showing competitive REITs practices.

1. Commercial Validity of Restrictions: The restrictions on transfer and conversion embedded in UPREIT agreements must be commercially justified and consistent with real estate industry practices. Courts are more likely to uphold discounts on partnership units when the restrictions align with typical commercial operations rather than appearing contrived for estate tax purposes.

2. Demonstrating a Non-Tax Purpose: Courts often assess whether the primary motive behind establishing partnerships or entities was estate tax savings. For UPREITs, the ability to diversify, manage, and develop real estate portfolios presents a clear and valid business reason beyond tax considerations. Taxpayers should clearly document these purposes, as they add legitimacy to the claimed discounts.

3. Emphasizing Minority and Marketability Constraints: When structured so that the deceased estate holds only a minority interest in the UPREIT partnership, this diminishes direct control over the asset, a point of strength for maintaining valuation discounts. Similarly, the partnership units' limited marketability due to transfer restrictions should be clearly evidenced to align with requirements for lack of marketability discounts.

   
   

Recommendation

As estate planners and taxpayers explore methods to manage estate tax liability in the face of judicial challenges, UPREIT structures offer a potentially powerful solution. By converting real estate holdings into UPREIT units, taxpayers can reduce their estate’s taxable value through discounts while ensuring a more diversified and liquid estate for heirs. However, given the IRS’s ongoing scrutiny of valuation discounts, careful planning and documentation are necessary. With the right structure, a clear commercial purpose, and adherence to industry standards, UPREITs are clearly the best tool for estate planning for large real estate owners.