While depreciation deductions are a standard and useful component of real estate tax planning, depreciation recapture can create a significant tax liability if a property is later sold at a gain. There are ways to mitigate this tax liability, however, and one of the strategies is the Umbrella Partnership Real Estate Investment Trust (UPREIT). UPREITs are structured to allow property owners to contribute real estate in exchange for operating partnership (OP) units—potentially avoiding a taxable sale at the time of contribution
In this article, Realized 1031 shares how UPREIT transactions can be used in certain circumstances to manage the effects of depreciation recapture.
Applying a depreciation schedule on an income-generating property is standard practice in real estate, accounting for the property’s wear and tear during its useful life. However, if you sell the asset for more than its adjusted basis, then depreciation recapture applies. This provision requires the taxpayer to report the portion of the gain attributable to prior depreciation deductions as ordinary income.
Let’s say that you bought a rental property for $300,000, and over the years, you claimed $50,000 in depreciation. The property’s adjusted cost basis is now $250,000. However, you were able to sell it for $400,000 thanks to favorable market conditions. From the $150,000 gains you made, $50,000 will be subject to depreciation recapture and the remaining to capital gains taxes. Since depreciation recapture follows ordinary income rates, you may need to pay up to 25% of that $50,000, while the remaining $100,000 would be subject to capital gains tax.This recapture tax can substantially reduce the net proceeds from the sale—especially for long-held or heavily depreciated properties.
One strategy that may help defer depreciation recapture and manage tax exposure is the Section 721 exchange. This strategy involves contributing your assets to an UPREIT. Unlike a direct sale, this contribution is generally not considered a taxable event, allowing the investor to defer capital gains and depreciation recapture at the time of the exchange.
In return for the contributed property, the investor receives operating partnership (OP) units. Income generated by the UPREIT’s underlying properties is typically distributed to OP unit holders in proportion to their ownership interests. However, OP units are not publicly traded, and their liquidity is limited compared to traditional REIT shares.
This structure is tax-deferred since no sale occurred. Keep in mind that depreciation recapture only applies when triggering events, such as real estate sales, happen. Since you simply exchanged your assets for OP units, you don’t immediately pay capital gains taxes or depreciation recapture. These liabilities remain deferred until you sell your OP units, convert them to REIT shares, or if the REIT itself sells the contributed property.
A further potential benefit of the 721 structure relates to estate planning. If OP units are held until death, the cost basis of the units may be adjusted to their fair market value at the time of inheritance—a process known as step-up in basis provision. The step-up effectively eliminates the previous capital gains and depreciation recapture, easing the tax burden of your heirs. However, the availability and treatment of step-up in basis depend on current tax laws and should be reviewed with an estate planning professional.
While not directly tied to mitigating depreciation recapture, the diversification offered by UPREITs can indirectly help with risk management. You convert your ownership of a single property into an interest in a larger, professionally managed, and diversified portfolio of real estate assets. This structure can help mitigate exposure to property-specific risks and may provide a more stable income stream.
In the event that liquidity is needed in the future, OP units may be converted to REIT shares and sold, at which point deferred taxes would generally become due. With proper planning, investors may use the income earned or proceeds from liquidation to meet tax obligations when they arise.
You shouldn’t enter an UPREIT for the sole reason of mitigating depreciation recapture. There are various considerations and trade-offs that can extend beyond the immediate tax deferral. As such, conducting a 721 exchange must be done with thorough planning and consideration of your long-term financial goals, risk tolerance, and investment goals.
A properly structured 721 exchange can be a useful strategy for deferring depreciation recapture and capital gains taxes, allowing investors to reposition appreciated property into a more diversified and passive structure. By contributing eligible assets to an UPREIT in exchange for operating partnership (OP) units, the transaction typically does not trigger an immediate taxable event.
However, before pursuing a 721 exchange, it’s important to fully understand the mechanics, risks, and long-term implications of UPREIT participation. Not all properties qualify, and not all investors will find the structure suitable. Working with qualified professionals can help ensure that any decision to use an UPREIT aligns with your investment objectives, tax strategy, and estate planning goals.
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://www.investopedia.com/terms/s/stepupinbasis.asp
https://www.irs.gov/pub/irs-drop/rr-99-5.pdf
https://www.investopedia.com/terms/d/depreciationrecapture.asp