Many real estate investors understand that with high appreciation comes high taxes, and as such, look for ways to delay tax liability in order to keep more of their equity working for them.
One strategy that has become popular in recent years is the umbrella partnership real estate investment trust (UPREIT). Its structure allows property owners to contribute highly appreciated property without recognizing gain or loss. How does that happen? How do UPREITs provide tax deferral benefits to property owners? Realized 1031 shares the answers below to help you better understand this tax management strategy.
An UPREIT is a legal structure that works as an operating partnership (OP). The partner with the controlling interest is the REIT. Meanwhile, investors contribute their real estate assets to the UPREIT to receive OP units, turning them into limited partners. These units are the economic equivalent of REIT shares, and investors receive dividends based on the performance of the UPREIT’s portfolio. Over time, the OP units can be converted to REIT shares and sold if you need liquidity.
Thanks to this structure, investors not only enjoy tax-deferral benefits but can also take advantage of passive income, professional management, and enhanced diversity.
The mechanism that enables tax-deferral for UPREIT contributions is the 721 exchange. Here’s how the process allows you to avoid immediate tax burden.
In a traditional real estate sale, you’re immediately liable for capital gains taxes. The substantial amount can take away a huge chunk of your profits. A 721 exchange allows you to avoid an official sale while still being able to access new investments. That’s because in an UPREIT structure, you contribute property instead of selling it. The IRS doesn’t recognize losses or gains due to the nature of the transaction.
In return for the asset contribution, you receive OP units. The IRS views this exchange as a continuation of your investment rather than a sale. As long as you hold those OP units, the tax liability is deferred.
You can hold your OP units indefinitely, and no one can compel you to convert them. This means that you can continue deferring capital gains taxes for as long as you need, helping immensely with tax planning and management.
Thanks to the nature of OP units, UPREITs provide more than just tax deferral in the context of tax management. Here are other benefits you can expect.
1031 exchanges and UPREITs are often compared against each other because of their similar tax-deferral benefits. The former involves swapping two like-kind properties, which also avoids the recognition of gains or losses. However, the 1031 exchange allows investors to maintain direct property ownership. Meanwhile, you lose control over your previous property as you contribute it to the UPREIT for OP units.
Given these differences, UPREITs are more suitable for investors who want hands-off involvement over their assets. Plus, UPREITs provide immediate diversification that 1031 exchanges can’t provide as easily. If you still want direct control over your properties, then the 1031 exchange may be the ideal option.
UPREITs provide a powerful way for property owners to defer capital gains and depreciation recapture taxes while transitioning from direct property ownership to a diversified, income-producing investment. Plus, benefits like step-up in basis make UPREITs ideal for estate planning and wealth transfer. When you’re wary about the huge tax bill of highly appreciated properties, this strategy might be the best option for you.
Sources:
https://taxfoundation.org/taxedu/glossary/step-up-in-basis/