One of the most powerful tax advantages investors can employ is depreciation — the process of deducting a portion of a property’s value over the years, even though the asset is actually appreciating.
For those considering entering umbrella partnership real estate investment trusts (UPREITs), it’s not unusual to wonder how depreciation can still be leveraged for tax management and wealth preservation. Below, Realized 1031 shares the answer to help you understand how these advantages apply.
Accounting depreciation, or simply depreciation, is the process of reducing the value of a property over time to recover the cost of wear and tear, obsolescence, and other issues. The IRS sets the schedules for depreciation, and for commercial properties, owners can depreciate for up to 39 years. Over time, depreciation reduces the cost basis of the property, and by extension, your tax liability as an investor.
However, if you sell the property at a profit, the IRS will “recapture” the depreciated amount and tax it following ordinary income rates. Add capital gains taxes to this amount, and you may face a significant reduction to your overall profits. Thankfully, strategies like UPREIT investing can help you defer tax liability and preserve more of your wealth.
UPREITs allow you to contribute your assets to an operating partnership (OP) in exchange for OP units — a process called the 721 exchange. The nonrecognition of gains and losses results in various tax benefits.
For those familiar with UPREIT investments, their most well-known benefit is the deferral of capital gains taxes. However, the same mechanism that applies to gains also applies to depreciation recapture. During the contribution, your basis carries over into the OP units, and so does the gain you made (that will later result in depreciation recapture). There is no official sale during the contribution, so you also avoid immediate recapture taxes.
The only time you become liable to depreciation recapture is when you convert the OP units to shares of the parent REIT, which triggers a taxable event, meaning you’ll need to pay the deferred capital gains taxes.
One lesser-known benefit of depreciation is that it can continue after you exchange property for OP units. Your units themselves won’t depreciate. Instead, the REIT can depreciate the properties within the UPREIT’s portfolio. This practice indirectly benefits you, as UPREIT distributions can be partially sheltered from tax deductions thanks to the lower cost-basis of the properties. This means that a portion of the income you receive can be treated as a return of capital rather than taxable income, deferring personal tax liability further.
Depreciation recapture can be entirely avoided when you hold your OP units until your passing. The units will undergo a step-up in basis, which adjusts their cost basis to their fair market value upon your death. In other words, the capital gains taxes and depreciation recapture are eliminated. While you won’t be around to enjoy this perk, your heirs will enjoy immense tax relief, especially for highly appreciated assets.
Depreciation and UPREITs work together to provide several tax advantages for real estate investors. By contributing property to an UPREIT, you get to defer capital gains and postpone depreciation recapture while still enjoying indirect benefits from ongoing depreciation within the REIT. With the guidance of a tax expert or financial advisor, you can leverage UPREITs as a powerful wealth-building strategy.
Sources:
https://taxfoundation.org/taxedu/glossary/step-up-in-basis/
https://www.investopedia.com/terms/u/upreit.asp
https://study.com/academy/lesson/property-depreciation-definition-importance-types.html