In the past, real estate developers earned money by collecting rent on completed properties or selling them. In recent years, 26 U.S. Code § 721—“Nonrecognition of Gain or Loss Contribution”—has offered property owners and developers different real estate financing methods.
Section 721, also known as the Umbrella Partnership Real Estate Investment Trust (UPREIT), enables developers to contribute their property to a real estate investment trust (REIT) in exchange for Operating partnership (OP) units.
Over the years, real estate developers have taken advantage of UPREIT benefits, including the following.
Enhanced Capital Access
Real estate is considered an illiquid asset. The developer must sell a property to earn money. However, the developer who contributes real estate to a REIT through the UPREIT process can obtain OP units. The developer can then improve capital flow by converting the units into cash or shares of the underlying REIT.
The developer involved with a 721 exchange can potentially obtain the necessary capital to fund future projects and obtain equity without relying on property sales. Additionally, if the developer decides to hold the OP units long-term, they could receive distributions and benefit from potential growth.
Deferred Taxes
Property sales generate capital gains. Realized capital gains mean the developer is responsible for paying taxes. However, participation in the UPREIT process could help defer taxes. Capital gains aren’t realized on OP units until converted into REIT shares or cash. Fewer taxes can provide the developer with more capital to reinvest.
Portfolio Diversification
Contributing properties through a 721 exchange allows the developer to diversify real estate holdings. This process helps reduce risk by providing exposure to an underlying REIT’s various properties and locations. It can also offer protection against market declines in a region.
Diversification means that a developer could generate and keep additional capital, which can be used to buy, build, or renovate new properties.
Management Reduction
When a property goes through the 721 exchange process, the developer is no longer responsible for property management. This task falls to the REIT. Less focus on operations and management allows the developer to spend time and resources on new projects rather than overseeing existing properties.
Strategic Partnerships
Participation in the UPREIT process can encourage the developer and REIT to form strategic partnerships. This could provide the developer access to larger capital pools, risk sharing, and the REIT’s property management expertise. The developer could also benefit from the REIT’s reputation and credibility.
Potential UPREIT Challenges
Though the UPREIT process could generate certain benefits, the developer should be aware of the following issues:
- Loss of direct control. When the developer exchanges property for OP units, they could lose control over the ability to make decisions or manage the asset.
- Tax implications. A 721 exchange allows the developer to defer capital gains taxes. However, tax liabilities arise when the developer converts OP units into REIT shares or cash. Tax law changes could also impact benefits.
- Lock-up periods. While an UPREIT process could provide liquidity, a lock-up period might forestall access to that capital. UPREIT agreements can impose restrictions on OP units to REIT shares for up to a year or longer.
- Valuation disputes. The initial valuation of the contributed property can be subjective. This could lead to unfavorable returns for the developer or potential disputes with the REIT.
- Performance and dilution risks. Returns depend on the performance of the underlying REIT. This, in turn, is subject to market movements and management effectiveness. Furthermore, additional unit issuances through the UPREIT could dilute the developer’s ownership stake over time.
- Conflict of interest issues. The REIT’s priorities (e.g., dividend distribution and shareholder interests) might not always align with those of the developer, who is the original property owner.
- Regulatory and structural risks. There is always the potential for REIT regulation changes, tax law shifts, or adjustments of corporate governance rules. Such actions could impact the financial and operational benefits of the UPREIT structure.
The Takeaway
While the UPREIT process can offer alternative methods of raising capital, reducing taxes, and managing risk, there are caveats. The 721 exchange can generate valuation issues, lock-up periods, and market volatility.
However, the savvy developer who understands how to work with the process could be well-positioned to take on more projects and sustain their position in a competitive environment. Careful planning, a clear understanding of the partnership agreement, and working with attorneys and other real estate professionals can help the developer use the UPREIT process to drive successful business 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.
