Umbrella partnership real estate investment trusts (UPREITs) offer a multitude of benefits like tax deferral and passive income, making them appealing to modern investors. This is all made possible due to the 721 exchange and the nature of the UPREIT structure itself. However, like any other investment vehicle, UPREITs have their own set of risks that investors must be aware of. Understanding these challenges and pitfalls helps you prepare and minimize their effects.
1. Taxes Aren’t Eliminated, Just Deferred
The primary benefit of UPREITs is that they help defer capital gains taxes. There is no recognition of gains or losses during the contribution, so capital gains won’t be taxed immediately. However, deferral doesn’t mean elimination. When a taxable event occurs, specifically the conversion of OP units to REIT shares, you will be liable to pay the deferred capital gains taxes and depreciation recapture when applicable.
Given this possibility, you’ll need to employ a few strategies to manage tax payments. Some investors choose to stagger conversions so that only a small amount of capital gains is recognized at a time.
2. REIT Performance Is Still Tied to Market Conditions
REIT dividends are not guaranteed. The UPREIT’s income is still tied to the performance of the underlying assets, meaning your wealth is also tied to the REIT’s performance. Given this fact, it’s important to be aware of the fluctuations in rental rates, inflation, and broader economic conditions. These factors, when favorable, can increase the value of your OP units and your income. The inverse is true when conditions are unfavorable.
There are also sector-specific risks to consider. For example, UPREITs that specialize in office buildings may still not be stable compared to rising industries like warehousing or data centers. In other words, if a sector struggles, the value of your investment might decline.
3. You Lose Control of Properties
Contributing your asset to the UPREIT relieves you of direct ownership and landlord rights. This effect can be a boon for investors who no longer want hands-on involvement over their properties. However, those who still want direct control may find UPREITs too limiting. These investors lose having a say over major capital decisions, tenant selection, and management.
4. Tax Complexities
Aside from the recognition of deferred capital gains upon the conversion of OP units, there are still a few tax complexities that UPREIT investors might face. First is the complexity of basis tracking. Errors could result in surprise tax bills or IRS disputes, so you must carefully track the adjusted basis of your assets to minimize the chances of these problems.
There’s also the possibility of the REIT selling the contributed property. Typically, there are provisions that delay this practice to protect you from unexpected tax liability. When the sale eventually happens, you may face a huge tax hit.
5. Liquidity Trade-offs
While UPREITs themselves are generally more liquid than investments like Delaware Statutory Trusts or direct property ownership, OP units may still be locked during an initial holding period. This typically lasts for a year, preventing you from accessing your capital if the need for cash arises. Even after the holding period, liquidity may not be immediate since you’ll have to assess market conditions to determine if selling at that moment will yield the most profits.
6. REIT-Investor Misalignment
As an OP unit holder, you have limited say in REIT governance. Decisions are made by the REIT’s management and board, and there’s always the possibility that their decisions may not align with your priorities or goals. For example, some REITs may focus on boosting short-term share price instead of long-term stability. This possibility makes it even more important to not just look at the promised dividends of an UPREIT, but also to evaluate the REIT and its governance. This way, you enter one that aligns with your goals.
Wrapping Up: UPREIT Investment Risks To Keep in Mind
UPREITs offer an attractive set of advantages like tax deferral and passive income, but a strategic investor must also take into account the risks associated with this investment vehicle. Market volatility, tax complexity, loss of control, and potential liquidity challenges can result in unwanted effects, so investors must examine these drawbacks and consider if they are worth the benefits UPREITs provide. Only then can individuals invest with confidence and the right expectations.
Sources:
https://www.investopedia.com/terms/u/upreit.asp
https://www.commercialcafe.com/blog/national-office-report-july-2025/
