DownREIT Explained: What It Is, How It Works, and Real-World Examples

Table of Contents#

1. What Is a DownREIT?
2. How Does a DownREIT Work?
3. The Two Types of DownREITs (And When to Use Each) 3.1. Type 1: Minimal or No REIT Capital Contribution 3.2. Type 2: Significant REIT Capital Contribution
4. Key Tax Advantages of DownREITs
5. Real-World DownREIT Example: A Retiree’s Apartment Building
6. Pros and Cons of DownREITs
7. DownREIT vs. UpREIT: What’s the Difference?
8. When Should You Consider a DownREIT?
9. Conclusion
10. References

1. What Is a DownREIT?#

At its core, a DownREIT is a joint venture partnership between a private real estate owner (or group of owners) and a REIT. Unlike a direct sale—where you transfer full ownership to the REIT for cash—a DownREIT lets you retain an interest in the property through a separate limited partnership (LP).

Here’s the basic setup:

• The REIT acts as the General Partner (GP): It manages day-to-day operations (leasing, maintenance, renovations) and makes strategic decisions.
• The owner acts as the Limited Partner (LP): You contribute your property to the LP in exchange for a stake in the partnership’s profits and losses.

The primary goal? To help owners defer capital gains taxes on appreciated real estate while giving REITs access to high-quality properties without upfront cash outlays. It’s a win-win—owners get tax relief and passive income, while REITs expand their portfolios efficiently.

2. How Does a DownREIT Work?#

Let’s break down the mechanics of a DownREIT step by step:

Step 1: Form a Limited Partnership (LP)#

First, you and the REIT create a separate limited partnership—distinct from the REIT’s main business. This LP will hold your property and any cash/contributions from the REIT.

Step 2: Contribute Assets (and Sometimes Cash)#

You transfer your appreciated property to the LP in exchange for:

• LP units: These represent your equity stake in the partnership (e.g., if your property is 75% of the LP’s value, you get 75% of the units).
• Cash (optional): Depending on the DownREIT type (see Section 3), the REIT may inject cash into the LP to fund renovations, pay off debt, or provide you with immediate liquidity.

The REIT, as GP, may also contribute cash or assets—but this varies by structure.

Step 3: The REIT Manages the Property#

As the GP, the REIT takes over all day-to-day management of the property. This includes:

• Finding and retaining tenants
• Handling maintenance and repairs
• Optimizing rents and cash flow
• Making capital improvements (e.g., adding a gym to a multifamily building)

You (the LP) have limited control—you can’t make day-to-day decisions but may have input on major choices (e.g., selling the property) if outlined in the partnership agreement.

Step 4: Distribute Profits (and Losses)#

The LP distributes net income (rental income minus expenses) to partners based on their ownership stakes. For example:

• If you own 80% of the LP units and the REIT owns 20%, you get 80% of the profits.
• Losses are also passed through to you, which can offset other taxable income (subject to IRS rules).

Step 5: Exit the Partnership#

Eventually, the partnership will sell the property (or the REIT may buy out your units). When this happens, you have two options:

1. Sell your LP units: You pay capital gains tax on the appreciation since you joined the DownREIT (not the full appreciation from when you bought the property).
2. Convert units to REIT shares: Some DownREITs let you swap LP units for publicly traded REIT shares—deferring taxes until you sell the shares.

The key here is tax deferral: You only pay taxes when you dispose of your LP units or REIT shares—not when you contribute the property to the DownREIT.

3. The Two Types of DownREITs (And When to Use Each)#

DownREITs are not one-size-fits-all. The structure depends on how much capital the REIT contributes to the partnership. Let’s explore the two main types:

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3.1. Type 1: Minimal or No REIT Capital Contribution#

In this structure, the REIT contributes little to no cash to the LP. Your property is the primary (or only) asset in the partnership. The REIT’s role is to manage the property—not to fund it.

How It Works:#

• You transfer your property to the LP.
• The REIT receives a small GP interest (1–5%) in exchange for management.
• You get LP units equal to your property’s fair market value (FMV).
• No cash changes hands unless the LP takes on debt (e.g., a mortgage) for improvements.

When to Use Type 1:#

This is ideal if:

• You want maximum tax deferral (no cash = no immediate taxes).
• You don’t need liquidity right now (e.g., you’re still working and want passive income).
• The REIT wants to add your property to its portfolio without spending cash.

Example:#

A local investor owns a fully leased industrial warehouse worth $5 million (purchased for$1 million, $4 million in appreciation). They form a Type 1 DownREIT with an industrial REIT. The REIT manages the warehouse, and the investor gets LP units worth$5 million. Taxes are deferred until they sell the units.

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3.2. Type 2: Significant REIT Capital Contribution#

In this structure, the REIT contributes a large amount of cash to the LP—often to fund renovations, pay off debt, or give you immediate liquidity. You still contribute your property, but the REIT’s cash increases the LP’s total assets.

How It Works:#

• You transfer your property to the LP.
• The REIT contributes cash (e.g., $2 million) to the LP.
• Your LP stake is calculated as:
  (Your Property FMV) / (Your Property FMV + REIT Cash)
• The REIT gets a larger GP interest (10–20%) or additional LP units.

When to Use Type 2:#

This is perfect if:

• You need immediate liquidity (e.g., retirement funds, college tuition).
• You want to pay off existing debt (e.g., a mortgage) without triggering taxes.
• You want to balance tax deferral with cash flow.

Example:#

A retiree owns a multifamily building worth $8 million (basis$2 million, $6 million appreciation). They want$2 million in cash for retirement but don’t want to pay $1.5 million in taxes (25$6 million). A Type 2 DownREIT lets them get $2 million in cash (from the REIT) while retaining LP units worth$6 million. Taxes are deferred on the $6 million—they only pay taxes on the$2 million if it’s treated as a distribution (consult a tax pro!).

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Key Difference Between Type 1 and Type 2:#

4. Key Tax Advantages of DownREITs#

The biggest draw of DownREITs is their tax efficiency. Here’s how they save you money:

1. Defer Capital Gains Taxes#

When you sell a property directly, you pay capital gains tax on the difference between the sale price and your basis (purchase price + improvements). With a DownREIT, you don’t sell the property—you transfer it to the LP in exchange for units. This is treated as a non-taxable contribution under IRS Section 721 (similar to a 1031 exchange but with REIT units instead of another property).

Your basis in the LP units is the same as your basis in the original property. So if you bought a property for $1 million (basis) and it’s worth$5 million, your LP units have a $1 million basis. When you sell the units later for$7 million, you pay taxes on **$6 million** ($7M – $1M)—not the$4 million you’d pay in a direct sale.

2. Pass-Through Income#

REITs are required to distribute at least 90% of their taxable income to shareholders. In a DownREIT, the LP’s income is passed through to you as ordinary income or capital gains. This can be more tax-efficient than receiving rental income directly—especially if the REIT has deductions (e.g., depreciation) that reduce taxable income.

3. Step-Up in Basis for Heirs#

If you hold LP units until death, your heirs get a step-up in basis to the FMV of the units on the date of your death. This means they can sell the units without paying capital gains tax on the appreciation during your lifetime—a huge estate planning win.

Important Caveat:#

Tax rules are complex! If the REIT gives you too much cash (e.g., more than 10% of your property’s value), the IRS may treat it as a partial sale—triggering immediate taxes. Always consult a real estate tax attorney or CPA before moving forward.

5. Real-World DownREIT Example: A Retiree’s Apartment Building#

Let’s put all this together with a realistic example that shows how a DownREIT benefits a typical owner:

Background:#

Sarah, 65, owns a 10-unit apartment building in Austin, TX. She bought it in 2000 for $500,000 (basis) and it’s now worth$3 million—$2.5 million in appreciation. She wants to:

• Retire and stop managing the property.
• Avoid a $625,000 capital gains tax bill (25$2.5 million).
• Get $500,000 in cash for travel.

Step 1: Choose a REIT Partner#

Sarah finds Austin Living REIT, a local multifamily REIT that specializes in growing apartment buildings. They agree to a Type 2 DownREIT (for cash).

Step 2: Form the LP#

They create Austin Living DownREIT LP. Austin Living REIT is the GP (5% interest for management), and Sarah is the LP.

Step 3: Contribute Assets#

• Sarah transfers her $3 million apartment building to the LP.
• Austin Living REIT contributes $500,000 in cash to the LP (for Sarah’s travel fund).

Total LP assets: $3 million (property) +$500,000 (cash) = $3.5 million.

Step 4: Allocate LP Stakes#

• Sarah’s stake: $3 million /$3.5 million = 85.71%
• Austin Living REIT’s stake: $500,000 /$3.5 million = 14.29% (plus 5% GP interest).

Step 5: The REIT Manages the Property#

Austin Living REIT:

• Raises rents by 10% (thanks to better leasing).
• Adds a fitness center ($100,000 from the REIT’s cash).
• Reduces vacancies from 8% to 2%.

The property’s net operating income (NOI) jumps from $180,000/year to$250,000/year.

Step 6: Distribute Profits#

The LP distributes 90% of NOI to partners (per REIT rules):

• Sarah gets 85.71% of $225,000 (90$250k) = $193,000/year.
• Austin Living REIT gets 14.29% = **$32,000/year** + a$12,500 GP fee (5% of $250k).

Step 7: Exit After 5 Years#

After 5 years, the property is worth $4 million (thanks to renovations and market growth). Austin Living REIT buys out Sarah’s units for **$3.428 million** (85.71% of $4 million).

Tax Outcome:#

• Sarah’s basis in the LP units: $500,000 (original property basis).
• Capital gains: $3.428 million –$500,000 = $2.928 million.
• Tax owed: 25% of $2.928 million = **$732,000**.

Total After-Tax for Sarah:#

• $500,000 upfront cash (non-taxable, per her CPA).
• $965,000 in distributions over 5 years ($193k x 5).
• $3.428 million sale proceeds –$732,000 taxes = $2.696 million.

Total: $500k +$965k + $2.696M = **$4.161 million**.

Compare to a Direct Sale:#

If Sarah sold the property upfront for $3 million:

• Taxes: $625,000.
• After-tax: $3M –$625k = $2.375 million.

The DownREIT gave Sarah $1.786 million more—and she didn’t have to manage the property for 5 years. Win-win!

6. Pros and Cons of DownREITs#

Like any investment, DownREITs have advantages and drawbacks. Let’s weigh them:

Pros of DownREITs#

1. Tax Deferral: The biggest win—you delay capital gains until you sell your units.
2. Professional Management: REITs handle all landlord duties (no more late-night repair calls!).
3. Partial Liquidity: Type 2 DownREITs let you get cash without selling everything.
4. Passive Income: You earn money from LP distributions while the REIT grows your property’s value.
5. Estate Planning: Heirs get a step-up in basis—eliminating taxes on your lifetime appreciation.

Cons of DownREITs#

1. Complexity: You’ll need a lawyer and CPA to structure the LP and navigate taxes.
2. Limited Control: As an LP, you can’t make day-to-day decisions (the REIT runs the show).
3. Liquidity Risk: LP units are less liquid than REIT shares—you may have to wait for the REIT to buy you out.
4. Conflicts of Interest: The REIT’s goals (maximizing shareholder value) may clash with yours (e.g., the REIT wants to sell, but you want to hold).
5. Tax Uncertainty: A misstep (e.g., too much cash from the REIT) could trigger immediate taxes.

7. DownREIT vs. UpREIT: What’s the Difference?#

If you’ve researched REITs, you’ve probably heard of UpREITs—the most common REIT partnership structure. How do they differ from DownREITs?

Key Takeaway:#

• Choose DownREIT: If you want a tailored structure (e.g., Type 2 for cash) or have a unique property.
• Choose UpREIT: If you want more liquidity (OP units convert to REIT shares) or prefer a simpler process.

8. When Should You Consider a DownREIT?#

DownREITs are a great fit if:

1. You Own Appreciated Real Estate: If your property has significant unrealized gains (bought 10+ years ago), deferring taxes is a huge win.
2. You Want to Stop Managing: If you’re tired of being a landlord, the REIT takes over.
3. You Need Partial Liquidity: Type 2 DownREITs let you get cash without selling everything.
4. You Want Passive Income: LP distributions let you earn money while you sleep.
5. You’re Planning Your Estate: The step-up in basis for heirs is a game-changer.

When to Skip a DownREIT:#

• You Need Full Cash Now: If you’re selling to fund a crisis (e.g., medical bills), a direct sale is faster.
• You Love Managing Property: If you enjoy being a landlord, keep doing it!
• Your Property Has Low Appreciation: If your basis is close to FMV, the tax benefits aren’t worth the complexity.

9. Conclusion#

DownREITs are a powerful tool for real estate owners looking to defer taxes, access liquidity, and tap into professional management—all without selling their property outright. Whether you’re a retiree wanting cash, an investor tired of tenants, or a family planning their estate, a DownREIT can help you achieve your goals.

But remember: DownREITs are complex. You must work with a real estate tax attorney and CPA to structure the LP correctly and avoid costly mistakes.

If you’re curious about DownREITs, start by talking to a REIT that specializes in your property type (e.g., retail, multifamily). Ask about their DownREIT structure, fees, and track record. With the right partner, a DownREIT could be the key to unlocking your real estate wealth.

10. References#

1. IRS Publication 541: Partnerships
2. Nareit (National Association of Real Estate Investment Trusts): DownREITs Explained
3. IRS Section 721: Non-Taxable Contributions to Partnerships
4. Real Estate Finance & Investment: The DownREIT Advantage (2022)
5. American Bar Association: REIT Partnership Structures

Always verify tax and legal information with a professional—rules change, and your situation is unique!