Among the opportunities for fractional real estate ownership, one increasingly popular vehicle is the UPREIT (Umbrella Partnership Real Estate Investment Trust), a REIT with some distinct components that can help real estate owners.
With an UPREIT, a property owner can contribute appreciated real estate to a REIT using a Section 721 exchange. Instead of cash or REIT shares, the owner receives an agreed-on number of operating partnership (OP) units. This exchange allows the owner to dispose of the property, including eliminating any active management, without paying capital gains taxes while continuing to enjoy the income that flows from the asset.
For example, suppose you own an apartment building that you bought for $1 million that is now valued at $1.5 million. If you have owned it for more than one year and you sell it, you would owe long-term capital gains taxes on the gain of $500,000. Depending on your current tax rate, you could pay as much as $100,000.
Instead of selling for cash, you may decide to employ a 721 exchange and trade your apartment complex to a REIT in exchange for some OP units. You will receive a prorated share of income from the entire REIT portfolio, not just your previous piece, and you can defer paying the capital gains and depreciation recapture.
Before the 1954 creation of Section 721, investors who wanted to use their property to purchase REIT shares would have to sell it first, incurring capital gains taxes, and use the remaining proceeds to buy them.
You can exchange OP Units for REIT shares.
If your disposition of the apartment complex was motivated by a need for cash, you can immediately transform the OP units into REIT shares. However, doing so will trigger the imposition of the capital gains and depreciation recapture taxes you sought to defer. If you are trying to reduce active management and maintain the cash flow, you can retain the OP units until you need liquidity. It is likely faster in most cases to convert your OP units into REIT shares and sell the shares than to seek a buyer for the property and complete the sale transaction.
However, suppose you prefer to spread out the capital gains taxes rather than paying them all at once. In that case, you can convert your OP units into REIT shares in increments, thus spreading the tax liability over a more extended period. By exchanging your property for OP units, you have increased the liquidity of the asset.
What are the risks of a 721 exchange?
One challenge to this approach is the difficulty of finding a REIT that is willing to participate, wants your property, and will offer the price you want.
OP unit holders do not have the same voting rights that shareholders of the REIT enjoy. This drawback will limit your impact on the REIT management.
Another concern is that if the REIT sells the property you used in the exchange, that will trigger the imposition of capital gains taxes and depreciation recapture even without you taking action to transform your OP units into REIT shares.
Also, when you want to sell REIT shares, you depend on the market to sell for an acceptable price. You could lose money by trading the property for OP units that are not worth the same amount when you ultimately sell the shares.
Finally, unlike a DST, exchanging into an UPREIT is a one-time deferral. The exchange means you no longer have a direct real property interest, so you can't exit the REIT using a 1031 exchange.
Investors considering the UPREIT strategy will benefit from the advice of a professional to determine whether it’s the right approach for your circumstances.
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.
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.
All real estate investments have the potential to lose value during the life of the investment. All financed real estate investments have the potential for foreclosure.
The income stream and depreciation schedule for any investment property may affect the property owner’s income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.
Costs associated with a 1031 transaction may impact investor’s returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.
All investments have an inherent level of risk. The value of your investment will fluctuate with the value of the underlying investments. You could receive back less than you initially invested and there is no guarantee that you will receive any income.
There is no guarantee that the investment objectives of any program will be achieved.
The actual amount and timing of distributions paid by programs is not guaranteed and may vary. There is no guarantee that investors will receive distributions or a return of their capital. These programs can give no assurance that it will be able to pay or maintain distributions, or that distributions will increase over time.
Hypothetical examples shown are for illustrative purposes only.
