Estate planning often involves the complexities of passing your wealth to heirs. One challenging thing you may learn during this process is the existence of the estate tax. Some investors dedicate most of their later years to strategies that help manage this tax liability and ease the burden on heirs. One potential strategy is the umbrella partnership real estate investment trust (UPREIT).
UPREITs may offer features relevant to estate tax planning. In this article, Realized 1031 reviews how UPREIT transactions can affect estate tax liability. Let’s take a closer look.
Also called the 721 exchange, UPREIT transactions are tax strategies enabled by Section 721 of the Internal Revenue Code. These exchanges are generally structured to defer recognition of capital gains or losses at the time of the transaction, meaning no immediate tax is typically triggered upon contribution of real property.
An UPREIT allows you to contribute your properties to the UPREIT in exchange for operating partnership (OP) units. The UPREIT owns underlying properties, which generate income that will be distributed to each investor on a current basis, subject to the performance of the assets and the terms of the partnership.
OP units may be convertible into shares of the parent REIT. These shares are often publicly traded and may offer greater liquidity than the OP units themselves. However, converting OP units to REIT shares is considered a taxable event, and any deferred gains may become subject to capital gains tax upon conversion or sale.
The estate tax is the tax levied on the transfer of a deceased person’s estate. As of 2024, the federal estate tax exemption amount is $13,610,000 per individual. Any amount past this will be taxed at rates as high as 40%. Your estate may include the following assets.
For real estate investors, estate tax planning can be an important consideration. The valuation of assets at the time of death plays a key role in determining the size of the taxable estate. Certain asset structuring approaches, including participation in an UPREIT, may influence how estate value is calculated under current tax law.
UPREIT participation through a 721 exchange may have implications for how real estate is treated within an estate. Below are several considerations relevant to estate tax planning:
One important benefit of OP units is that they receive a step-up in basis upon your passing. This means that the cost basis of the OP units resets to the current fair market value as of the date of death. As a result, previously deferred capital gains and depreciation recapture associated with the contributed property may not be recognized. If heirs sell the units shortly after inheriting them, taxable gains may be limited, depending on the sale price and the adjusted basis.
Although OP units are valued at FMV for estate tax purposes, they may qualify for valuation discounts based on factors such as lack of control or lack of marketability. These discounts can lower the reported value of the OP units within the taxable estate. This benefit doesn’t usually apply to directly owned real estate, which is typically appraised at full market value.
OP units are typically less liquid than publicly traded REIT shares. If an estate has limited liquid assets available to cover potential estate tax liabilities, heirs may face challenges in meeting those obligations. In some cases, the sale of OP units under time constraints could result in less favorable outcomes. For this reason, liquidity planning is an important part of comprehensive estate planning involving UPREITs.
More than the impact on estate taxes, UPREIT participation may support other aspects of estate planning.
It can be simpler to divide OP units among your heirs compared to real estate. The latter can be harder since beneficiaries may find it hard to navigate shared ownership, which may lead to issues that sometimes escalate into a forced sale. OP units can typically be divided into more precise portions, allowing for proportional allocation based on the estate holder’s intentions. This may support a more manageable and equitable distribution of estate assets.
The UPREIT structure limits the influence and control of investors. This can reduce the administrative burden for heirs who may have limited experience in real estate investing. Beneficiaries are not responsible for day-to-day management decisions related to the properties held within the UPREIT.
UPREITs may provide access to new markets or geographical locations. This can offer exposure to different sectors or locations, which may be helpful for heirs who live in various parts of the country or are less familiar with direct property investment. As with any investment, diversification does not guarantee returns or eliminate risk.
While UPREITs can offer structural advantages in estate planning, they also involve certain risks and limitations that should be carefully evaluated before incorporating them into a long-term strategy.
Loss of Direct Control
Once real property is contributed to an UPREIT in exchange for OP units, the investor no longer retains control over the asset. Decisions related to property management, refinancing, or disposition are made by the UPREIT’s general partner or sponsor. This can be a disadvantage for those who prefer to direct how assets are managed during their lifetime or by their heirs.
Illiquidity of OP Units
OP units are typically not publicly traded and may be subject to holding period restrictions. This lack of liquidity can create challenges for heirs who need to cover estate tax obligations or other expenses. Converting OP units into publicly traded REIT shares may provide liquidity, but such conversions are taxable events and may not be immediately available.
Tax Law Uncertainty
The tax treatment of UPREIT transactions, including step-up in basis and valuation discounts, is based on current federal tax law and administrative guidance. These rules may be subject to change through future legislation or regulatory action, potentially altering the anticipated estate planning outcomes.
Market and Operational Risks
As with any real estate investment, the performance of the properties held by the UPREIT can be influenced by economic conditions, tenant performance, interest rates, and property-specific risks. Distributions to OP unit holders are not guaranteed and depend on the performance and policies of the UPREIT sponsor.
Complexity and Suitability
UPREIT participation involves complex legal, tax, and investment considerations. Estate planning using UPREITs may not be suitable for all investors and should be evaluated in the context of broader financial goals and family needs. Professional guidance is essential to determine whether this structure aligns with an individual’s estate and tax planning objectives.UPREIT participation may serve as one option for addressing capital gains deferral and managing estate tax exposure under current law. Features such as the potential for a step-up in basis and eligibility for valuation discounts can support certain estate planning strategies. However, UPREITs also involve risks, including illiquidity, lack of control, and sensitivity to changes in tax law.
As with any estate planning approach, evaluating the suitability of an UPREIT structure depends on an individual’s goals, risk tolerance, and broader financial situation. Investors should consult with qualified tax, legal, and financial professionals to assess whether this strategy aligns with their overall objectives.
The tax and estate planning information offered by the advisor is general in nature. It is provided for informational purposes only and should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.
Article written by: Story Amplify. Story Amplify is a marketing agency that offers services such as copywriting across industries, including financial services, real estate investment services, and miscellaneous small businesses.
Sources:
https://taxfoundation.org/taxedu/glossary/step-up-in-basis/
http://www.ers.usda.gov/topics/farm-economy/federal-tax-issues/federal-estate-taxes