Real estate investors are always searching for ways to save on taxes. One of the biggest tax events a real estate investor will face is when their property is sold for a profit. To mitigate tax consequences from the sale of property, investors will often use a 1031 exchange. However, a 1031 exchange isn’t the only tool available for tax mitigation. Its cousin, the 721 exchange, provides a few alternative benefits to investors.
What is an UPREIT?
A UPREIT is an Umbrella Partnership Real Estate Investment Trust. It is a REIT that holds real property.
Properties can come into the trust through a 1031 exchange (i.e., the REIT-acquired properties from investors). In return, investors receive operating partnership (OP) units in the trust. In this process, investors exchange the management of real property for the passive ownership of OP units.
Through this exchange, which is called a 721 exchange, investors defer capital gains on their properties. Like real property, the UPREIT distributes income to investors when available. This income is guaranteed by the REIT and shouldn’t fluctuate much.
The actual process generally has investors exchanging into a Delaware Statutory Trust (DST) through a 1031 exchange. Then, it is exchanged into the UPREIT. This path allows investors to take advantage of DSTs while searching for the right UPREIT.
Be aware that most investors won’t have their property acquired by a REIT. REITs are interested in investment-grade real estate assets, which not all smaller investors hold. This can leave the pool of potential investors fairly small.
Next, we’ll look at why an investor might want to exchange into a UPREIT.
Why Use a UPREIT?
Selling a property outright is fraught with many potential tax implications. The two main ones are capital gains and depreciation recapture. Both can be significant.
Utilizing a 1031 exchange allows investors to defer capital gains and depreciation recapture taxes. However, the main problem is finding a suitable like-kind property to exchange into.
Investors who can’t find a like-kind property to exchange into may consider DSTs. DSTs may offer more readily available options for a 1031 exchange.
Additionally, if a REIT isn’t available to acquire an investor’s property, they can utilize their DST through a 721 exchange, as mentioned above. Exchanging into a UPREIT would have the benefit of providing more liquidity (over real property) in the form of OP units and potential shares in the REIT. REIT shares can be sold on the open market at any time.
Investors should be aware that once OP units are converted to REIT shares, they’re no longer considered real estate. The result is that REIT stock isn’t eligible for any future 1031 exchanges.
When considering any REIT, investors should perform their due diligence on the REIT to better understand its investment philosophies, fees, and returns.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Investors who have sold real estate and executed a 1031 Exchange into a DST may execute future 1031 Exchanges and continue to defer taxable gains. Alternatively, a client may enter into a transaction pursuant to IRS Code Section 721 (also known as an UPREIT transaction). In an UPREIT transaction, Clients will receive, at the REIT Sponsor’s option, cash or OP units. OP units are units of an operating partnership that is wholly owned by a REIT. If the client receives OP units, he or she has exchanged into a security and therefore no longer owns real estate and cannot execute another 1031 Exchange out of the OP units and into other real estate. However, pursuant to IRS Code Section 721, the UPREIT transaction into the OP units may qualify as a tax-deferred exchange. The disposition of their interest in OP units will result in a taxable transaction, including the recognition of their deferred capital gain and any depreciation recapture. The client’s gain will only be recognized upon sale or disposition of the OP units.
There is no guarantee that an UPREIT transaction will occur. The option for this transaction is at the discretion of the REIT Sponsor. Some DSTs allow the client to choose whether to take OP Units or cash. Clients should consult the prospectus and their advisor regarding the specifics.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.