Plenty of articles in recent months have detailed real estate volatility, and for good reason:
- Higher inflation rates are impacting the costs connected with real estate ownership
- Ongoing Federal Reserve hikes to the Effective Federal Funds Rate means hikes to the cost of borrowing capital
As such, if you own real estate for investment purposes, you might find it challenging to sell your asset in the current situation.
One possible solution might be 26 U.S. Code § 721: “Nonrecognition of Gain or Loss on Contribution” – otherwise known as the UPREIT process. When done correctly, the UPREIT could be a useful tool to help you offload appreciated property into another potentially more viable investment.
A Brief Explanation
UPREIT is short for “Umbrella Partnership Real Estate Investment Trust.” Simply put, that trust is a partnership between you, the investor, and a real estate investment trust (REIT) that might want your property. Once you and the REIT agree:
- You contribute your property to the REIT-owned operating partnership or OP
- You receive OP units – or an interest – in that partnership
- You convert the OP units into shares of REIT stock
The key is to find a REIT interested in your property and willing to enter into an UPREIT agreement with you.
UPREIT Investment Advantages
In today’s evolving real estate landscape, the UPREIT process can offer the following benefits:
Portfolio diversification
Trading your property for OP units can give you access to high-quality real estate owned and managed by the REIT. Many REITs have diversified portfolios (either by asset type or geography). Such diversification could offer a little more stability. As an OP holder, you could also receive distributions from the REIT’s income.
Tax advantages
No cash changes hands through the UPREIT process. This means no money is subject to capital gains or depreciation recapture taxes. You aren’t taxed on anything until you convert your OP shares into REIT stock and sell it. But remember that the distributions you receive from the REIT ARE taxable.
Higher degree of liquidity
An UPREIT can help you convert your illiquid real estate asset into one that can be more readily converted into cash. Again, you could convert your OP units into REIT shares then sell those shares.
Passive ownership
You no longer have to worry about the “trash, toilets, and tenants” involved with direct ownership of your property. The REIT’s qualified staff takes responsibility for acquisitions, dispositions, and managing properties.
UPREIT Limitations
If you decide to swap your property through the 721 exchange process, it’s important to understand the risks:
One-time tax deferral
It was pointed out in the section above that the UPREIT exchange wouldn’t trigger a taxable event. But that process is one-and-done. You can’t take those OP units (or REIT shares, for that matter) and swap them into another investment without generating capital gains taxes.
Complicated tax filings
There is more paperwork affiliated with an UPREIT. As an OP unit holder, you’re subject to tax filing requirements in each state where your operating partnership conducts and transacts business. This might mean multiple tax forms.
Market volatility
The REIT shares you receive from an OP unit conversion can be sold for cash. But those shares' value depends on market pricing (especially if your REIT is traded on the public exchanges). This might mean that the value of those shares is far less than what your original property was worth.
Property desirability
While you believe the small retail center you own and operate is a wonderful investment, the REIT you want to partner with might disagree. Many REITs will only consider high-quality real estate with specific returns. If your property doesn’t fit those requirements, the UPREIT won’t take place.
UPREITs and Today’s Real Estate
Utilizing the section 731 process to navigate today’s real estate situation can generate certain benefits, depending on your investment goals and objectives. As with any investment, UPREITs also have their limitations. Be sure to check with your financial and tax professionals to discuss the pros and cons of the UPREIT process and whether it’s suitable for your particular situation.
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.
