Many investors now recognize the benefits of umbrella partnership real estate investment trusts (UPREITs), such as tax deferral and passive income. However, you shouldn’t just hop on the trend without fully understanding exactly what’s on the other side. There are many legal pitfalls that unaware investors might fall into, resulting in loss of profits or even their tax-deferred status.
In this article, Realized 1031 shares common UPREIT law issues and pitfalls to help you be aware of. Let’s take a closer look.
1. Not Reviewing the Partnership Agreement Closely
The operating partnership agreement serves as a rulebook, outlining various aspects and processes within the UPREIT. These include the following.
- Distribution of dividends
- Conversion of OP units to REIT shares
- Liquidity and exit provisions
- Tax protection provisions
- Management and control
- OP unit valuation methods
Given the scope of the partnership agreement, it may be easy to overlook certain matters like the holding period or deferral of distributions. Many investors believe these agreements are boilerplate or investor-friendly, only to be surprised by terms or limits they weren’t aware of. As such, a savvy investor would avoid summaries and rely on reviewing the entire agreement line by line to find any potential red flags.
2. Failing to Structure the Contribution for Tax Deferral
The main law that allows you to defer capital gains taxes is Section 721 of the Revenue Code. However, you can only enjoy the tax benefits if you follow the proper structure of the property contribution. While the rules aren’t as rigid as 1031 exchanges, a 721 exchange still has a few major rules you’ll need to follow.
For example, receiving any cash as part of the contribution will be considered boot and is taxable. Contributing to the wrong entity can also trigger tax liability. A common example of this is exchanging your assets for a C corporation instead of a partnership.
Most investors won’t be experts in the 721 exchange contribution process outright, so it’s easy to miss these pitfalls. The best practice is to work with a tax professional or investment attorney who can help you navigate the contribution process.
3. Misunderstanding the Scope of Tax Protection Provisions
An UPREIT usually offers tax protection provisions, which are conditions that disallow the REIT from refinancing or selling contributed properties in a way that triggers taxable gains. These provisions usually last between seven and 10 years. However, many investors fail to understand how these provisions work, and they will later be surprised by tax liability when the provisions are over.
In truth, some UPREIT tax protection clauses include exceptions. The agreement may permit sales in cases of portfolio rebalancing or mergers or allow for substitutions that don’t fully preserve the contributor’s deferral status. Even worse, some agreements don’t include tax protection at all, or only promise to “use reasonable efforts” to avoid triggering gains.
Scrutinizing the tax language closely with the help of a tax advisor or attorney is key to understanding the extent of these conditions or if they exist at all. If not, then you could advocate or negotiate for better terms before contributing your property.
Wrapping Up: UPREIT Legal Pitfalls to Keep in Mind
UPREIT rules are complex, and it’s easy for investors to fall into legal traps due to the promises offered by this investment vehicle. To avoid unwanted surprises and minimize the chances of massive losses, research and guidance from professionals are necessary. The knowledge and support can help you unlock UPREIT benefits with confidence and certainty.
Sources:
https://www.lawinsider.com/dictionary/tax-protection-agreements
https://www.taxnotes.com/research/federal/usc26/721
https://www.investopedia.com/terms/r/realestatelimitedpartnership.asp
