Capital gains taxes can make a considerable dent in your overall profits from a real estate sale, especially if you’re in the top tax brackets. It’s not surprising that many investors look for ways to defer tax liabilities. Several types of investment vehicles offer such benefits, and among these is the 721 Exchange, also called UPREIT.
In this setup, you contribute your property to an umbrella partnership real estate investment trust (UPREIT) in exchange for units of equity interest. As long as the property remains unsold by the REIT, you can defer tax liabilities. This process may sound complicated, and it is. Thankfully, Realized 1031 has shared a comprehensive guide to help you peel back the layers and get an in-depth understanding of this investment vehicle. What is an UPREIT? What are its pros and cons? Can you 1031 into a REIT? Keep reading to learn the answers to these questions.
An UPREIT or 721 Exchange is an investment vehicle that lets you exchange your real estate property for units in an operating partnership (OP). This exchange is just one of the many strategies that investors use to defer capital gains taxes. Other popular ones include 1031 Exchanges and deferred sales trusts.
The 721 Exchange follows the 26 U.S. Code § 721: “Nonrecognition of Gain or Loss on Contribution, which is also known as the UPREIT process. For an investor to become liable for capital gains taxes, they must “sell” the asset and gain profit. However, as the alternate name implies, UPREIT is an exchange. As long as the REIT doesn’t sell the property, or until you convert the OP units into REIT shares, you have not sold anything. Thus, until such triggering events happen, you’re not liable to pay taxes.
REITs have been around since the 1960s, mainly serving as a way for small-time investors to tap into income-producing, institutional-grade assets. The Tax Reform Act of 1986 expanded the power of REITs, allowing them to own and operate real estate properties as well. This change allowed for the creation of UPREITs, offering an efficient way for investors to gain liquidity without paying taxes immediately.
There are a few terms that you must understand first before you can get a deeper understanding of UPREITs.
Now that we’ve made the terms clearer, here’s how an UPREIT transaction works.
Both the 1031 Exchange (like-kind) and 721 Exchange (UPREIT) “swap” assets to defer taxes. However, these two have unique distinctions that make either one the better choice for certain types of investors.
A like-kind or 1031 Exchange requires the seller to reinvest the proceeds from a property sale to another property that has similar characteristics. For example, you can only swap from an apartment building to a townhouse complex. You cannot exchange from an apartment building to a single-family home. Once you do find a suitable property, you can enjoy tax deferrals and continue earning. As long as you keep finding new like-kind properties every time you sell a real estate asset, you can maintain the tax deferral indefinitely.
The IRS also has strict regulations when it comes to 1031 Exchanges. Investors must finish the transaction within 180 days, and they must find a property that matches or exceeds the value of the relinquished one. Failing to fulfill these requirements means the investor won’t enjoy tax deferrals.
On the other hand, a 721 Exchange swaps a property for OP units. There’s no need to find a similar property, just a REIT that will take control of your property. After the exchange, you own interests in the UPREIT and potentially earn income. You can opt to convert the units to shares, making them taxable. You cannot continually exchange shares as you would with a 1031 Exchange, so you can only defer taxes in an UPREIT once. Thankfully, you don’t have to convert all your units to shares in a single event. You can still convert incrementally to lower your tax bills.
Another similar investment vehicle to UPREITs is the Delaware Statutory Trust or DST. The latter is an investment vehicle where a property seller exchanges proceeds from a real estate sale for fractional interest in the trust. This trust owns other investments that also earn income and dividends. If you’re thinking that this structure is familiar, you’re on the right track. DSTs are actually the first phase of a 721 Exchange. However, the similarities end here.
The second phase of the UPREIT is the conversion of OP units to shares, a taxable event. In a DST, the trust can be dissolved, but the proceeds can still be reinvested into another DST, which allows the investor to continue deferring taxes so long as they can find another trust.
DSTs have lower minimums compared to UPREITs. Most sponsors — the companies that offer DST properties — require as low as a $100,000 investment. However, an UPREIT manager may require up to $500,000 in initial investment. As such, small-time investors may face some barriers before they can enjoy the benefits of UPREITs.
In exchange for lower minimums, DSTs have longer holding periods. The time frame can be anywhere between five and 10 years, with some lasting for 12 years. During this period, the asset remains illiquid. On the other hand, UPREITs have a shorter holding period. You’re restricted from converting your units to shares for only a year in some cases. As such, OP units are more liquid.
Another potential advantage of UPREITs is that they could be a safer investment than DSTs. A DST makes income from the underlying properties, making them dependent on the performance of the assets. While the same concept applies to UPREITs, the REITs typically manage a much larger pool of diversified assets. This larger pool of investments makes it less prone to huge losses.
For a more comprehensive comparison of DSTs and UPREITs, browse the article we shared here.
DownREITs also exist, unsurprisingly. These structures are similar to UPREITs in many areas, but the main difference is the relationship between the investor and the REIT. While UPREITs treat investors as operating partners, a DownREIT creates a joint venture between the investor and the REIT.
Thanks to the added control for investors, DownREITs are popular among those who believe that the value of their property will exceed the REIT-owned property. However, creating a DownREIT is complicated. This structure also tends to attract the attention of the IRS, which may make the process more stringent and subject to detailed scrutiny. Investors must ensure they comply with all relevant regulations and requirements to avoid potential tax issues and penalties.
A 721 Exchange provides several benefits. Understanding these advantages can help you decide if this investment vehicle fits your financial goals.
Capital gains taxes can take a chunk from your profits, especially if you’re in the top tax bracket. A property sale that resulted in $50 million in capital gains could become $40 million after paying the tax liability. Plus, we haven’t included other fees as well as depreciation recapture. A 721 Exchange helps you delay this massive loss thanks to the tax deferral benefits. As long as you hold your OP units, you won’t have to pay the capital gains taxes.
Another major benefit of UPREITs is truly passive income. In a typical 1031 Exchange, you will still play an active role in the overall management and operation of your property. A UPREIT lets you give up control if you’re already looking to be less involved and simply receive the dividends. The UPREIT will oversee everything else, ensuring that the portfolio of assets remains profitable and distributing the earnings to each unitholder. This advantage is ideal for people who are looking to retire and those considering long-term investment goals.
An increase in asset liquidity can help you easily sell investments for cash. This advantage is beneficial for those who may need funds on short notice. However, most types of real estate investments are illiquid. For example, the DST contracts we mentioned have holding periods that could span a decade. Even regular properties that haven’t undergone any sort of exchange are pretty illiquid.
721 Exchanges are a notable exception in real estate investments. With holding periods that can be as short as a year, you can convert your OP units to shares. These shares can then be sold to other interested investors, liquidating them into cash. Publicly traded REITs, in particular, have a large market thanks to public exchanges. Given this liquidity, you can easily reallocate your capital as your needs evolve.
As soon as an investor becomes an operating partner in a REIT, they also tap into the diverse assets of the REIT. These trusts may hold assets across various geographic regions and asset classes. With these diverse investments, REITs are potentially more immune to market fluctuations. This advantage helps with risk management and gives you access to revenue from multiple sources.
Another potential advantage of UPREITs is that they can make it easier for property owners to pass on assets to their heirs upon death. You can include in the underwriting how the units will be split for each trust beneficiary, and they get to decide whether they’re going to hold the OP units or convert them into shares. Given how the OP units pass through a trust, the beneficiaries can also receive a step-up in basis and potentially eliminate the need to pay capital gains altogether.
All investment vehicles have inherent risks and challenges associated with them, and UPREITs are no exception. Knowing the possible disadvantages may help you navigate these ventures effectively.
The value of your REIT shares fluctuates depending on a lot of factors, such as market conditions, interest rates, and economic cycles. The volatility may lead to losses if the market becomes unfavorable. One specific factor that affects real estate investments is interest rates. Rising numbers can increase borrowing costs and potentially lower property values, lowering the value of your REIT shares as well.
UPREIT managers are usually composed of top experts, with years of experience overseeing billions worth of real estate assets. However, this fact doesn’t mean that the team will always make the best decisions. Mistakes and poor planning can negatively impact the value of the properties and affect your shares. Aside from bad management, UPREITs can also encounter issues with unitholders who have other priorities. The latter may want short-term gains, while the REIT manager is more focused on long-term stability.
While UPREITs offer tax deferral benefits, they also involve complex tax considerations. Improper handling or misunderstanding of tax laws may lead to unexpected liabilities and penalties. Plus, unitholders will eventually have to pay taxes, no matter how long they prolong holding on to the OP units. As soon as they convert the units to shares, then they will have to pay taxes.
One other aspect you’ll have to consider is filing requirements. OP unitholders must file taxes in each state where the REIT has a transaction. This makes sense, given how you’re also earning dividends from all the properties managed by the REIT, no matter their location. As such, it’s essential to work with tax experts to avoid missing payments once you do have to file taxes.
As we mentioned, UPREITs do have holding periods, but these aren’t as long as DSTs. Given that, one or two years may still be too lengthy for some investors. If you need easy access to capital when needed, then UPREITs may present a challenge. Similarly, market conditions can affect the liquidity of your shares. Selling them during a market downturn will lead to potential losses, so you will need to wait for the market to recover before you can liquidate the shares.
Changes in real estate or tax regulations can have a significant impact on the operation and profitability of UPREITs. Some examples are changes in tax laws, zoning regulations, and property management requirements.
Future Tax Rates
Investors should consider the possibility that future changes in tax laws or rates could affect the tax treatment of their investment when they eventually sell their REIT shares.
Depreciation Recapture
If the property has been depreciated, a portion of the gain upon conversion of OP units to REIT shares could be subject to depreciation recapture, which is taxed at a higher rate.
Limited Liquidity
The ownership units of a private REIT are not publicly traded and are typically less liquid than REIT shares. The process and timing for converting OP units into REIT shares should be clearly disclosed, including any restrictions or lock-up periods.
Valuation Methodology
The method used to value the real estate contributed to the UPREIT and the corresponding OP units should be disclosed. Investors should understand how their properties were valued and how this impacts the number of OP units they receive. Conversion Ratio: The terms under which OP units can be converted into REIT shares should be clearly explained, including any adjustments that might affect the conversion ratio over time. Potential Dilution: Investors should be aware that the issuance of new OP units or REIT shares could dilute their ownership interest. (these could probably be more briefly summarized just as valuation and conversion risks)
REIT Performance
The performance of the REIT, including its dividend yield, property management, and overall financial health, directly impacts the value of OP units and converted REIT shares. Investors should review the REIT’s financial statements and disclosures about its property portfolio, management strategy, and market conditions.
Property-Specific Risks
Investors should be informed about any specific risks associated with the properties being contributed to the UPREIT, such as location, tenant quality, lease terms, and market trends.
Choosing UPREITs solely for the tax benefit is not a good practice. You must also consider other goals and investment needs to determine if this approach is ideal for you. Here are other scenarios that make these investment vehicles more compelling for certain types of investors.
At some point in their lives, many investors will want to step down from any active role over their assets and simply enjoy the income stream. UPREITs provide a truly passive income in most cases, with the trust overseeing every other aspect of the operation. Retirees and individuals who want to supplement their main income source may find UPREITs particularly appealing due to this benefit.
An institutional-grade asset is a property that’s large enough to attract national and international investors. Typically, these properties have values of $50 million and more. Examples are high-end hotels and large commercial buildings. These properties have the potential to earn a high income, making them attractive to many. Most small-time investors won’t have enough capital to access these assets. However, buying OP units in an REIT is one method to tap into the high-value properties. An investment as low as $500,000 may be enough in some UPREITs.
After mergers, acquisitions, or strategic real estate consolidation, you may have excess real estate assets that are no longer part of your core operations. This asset can go unutilized or underused, hemorrhaging resources because of property tax and maintenance needs. Exchanging the excess property for OP units can relieve you of the financial burden and help you gain another income stream.
Instead of owning real estate, having OP units in an UPREIT gives you more liquidity over your assets. Some investors may want the flexibility of 721 Exchanges when they see the need for liquid cash in the near future, maybe two to three years after entering the contract. They have the option to convert units and sell the shares once the holding period is over.
Investors who want to focus on estate planning and wealth transfer will find UPREITs a good vehicle for their assets. REITs are, by design, trusts. Therefore, you can assign beneficiaries for your units upon death. These shares are easier to distribute because, unlike real property, they do not require complex valuation and division processes. Your beneficiaries can enjoy a more straightforward and equitable distribution of wealth.
Some commercial real estate properties fail to generate substantial income because of ineffective management. For investors who want more professional teams to handle all aspects of property acquisition, management, and maintenance, UPREITs are an ideal choice. While you give up ownership of the underperforming property, you can start earning income brought over by a professional manager.
An investor may ask questions like “Can I 1031 into a REIT?” In fact, this practice is possible. You can combine these two to help ensure that the property you have can qualify for the REIT.
Check out our more comprehensive guide for this process here.
Given how 1031 to REIT exchanges are allowed, you can also enter a REIT through a DST. Not all DSTs will allow this process, so you must first look for a sponsor that offers a 721 option. After you’ve entered the DST and finished the outlined holding period, the sponsor can perform a 721 exchange , pulling the property “UP” into the UPREIT in exchange for OP units. Of course, the real estate asset should meet the REIT’s requirements.
Unfortunately, OP units or shares in a UPREIT cannot be exchanged for a like-kind property. However, a 1031 Exchange can happen indefinitely. As long as you can find a suitable real estate asset to swap with, you can defer capital gains taxes and potentially continue earning. If you 1031 into REIT, you effectively end this cycle. Given how converting OP units to shares is a taxable event, you’re no longer “exchanging” anything. Therefore, a 1031 Exchange is no longer possible. What you can do next instead is use the shares as funding for another property that you can later use in a 1031 Exchange.
On the whole, REITs would have a large team of experts behind them. These managers have qualifications that make them compliant with regulations set by the Securities Exchange Commission (SEC) and other related governing bodies. Still, REIT companies are not created equal. Careful evaluation on your end is crucial to ensure that the UPREIT you choose aligns with your financial goals and risk tolerance. When looking for a REIT, here are some crucial factors that you should consider.
REITs come in several types. To be clear, UPREIT does not belong to these types as it’s simply a structure of REIT. In this list, we will talk about where the REIT sources its income.
To learn about the risks and opportunities associated with each type, you can work with financial advisors or investment analysts. These experts have in-depth insight that helps you understand the REIT type that fits your financial goals.
Another aspect you should evaluate is the portfolio composition of each REIT. Most trusts specialize in specific property types, whether it’s commercial office buildings, multi-housing units, or retail spaces. Each sector has its own market dynamics and risk factors.
Aside from the REIT’s niche, you should assess its geographic diversification. A well-diversified REIT should have properties in multiple geographic locations to mitigate regional market risks.
The management team behind the trust can play a huge role in the performance of the REIT. It’s important to do your research on the background and experience of the trust’s management team. Find options that have a strong track record in real estate investment.
Another aspect to look into is the governance style of the REIT. The board’s governance practices can affect the overall performance and shareholder value of the REIT. We recommend checking their transparency, accountability, and alignment with your own goals.
There are two key aspects that you should assess when selecting a REIT: funds from operations (FFO) and adjusted funds from operations (AFFO). The first metric reflects the cash the trust generates from everyday operations. On the other hand, the AFFO is the funds left over after capital expenditures. This second metric is usually the more accurate measurement of available cash that the trust will later distribute to unitholders.
One other financial metric to assess is the dividend yield. Compare the value to other industry averages to learn if the expected return on investment is competitive or not.
We also recommend evaluating each REIT’s potential for future growth. One area that helps provide a clear picture of this potential is the trust’s acquisition strategy. The ones that are more likely to grow have well-executed acquisition approaches that adapt to market changes while predicting future trends.
You should also take a look at the REIT’s development projects. If these look feasible and eventually become successful ventures, then the projects could add significant value to the REIT’s portfolio and potentially increase your units’ value as well.
Outside of the REIT itself, you’ll also want to look at the market conditions. Having a grasp of the bigger picture can help you determine if the REIT will perform well in the future. For example, certain sectors may be more profitable in the next few years, like real estate involved in the e-commerce industry. Growth in e-commerce could then affect real estate in the retail industry. In this case, it may be safer to invest in trusts owning e-commerce real estate assets.
As we mentioned, REITs have their own requirements for the types of properties they want to include in their portfolio. Here are the common features that may make your real estate asset attractive to these trusts.
The most popular way to exit a 721 Exchange is by converting the units to shares. However, this method may not be the most cost-effective for some investors. There are other exit strategies you can follow to avoid triggering the taxable event or ensure that you maximize the proceeds you receive at the end.
Instead of converting your OP units to shares as soon as the market is favorable, you can opt to hold them for an extended period. This practice doesn’t just defer capital gains taxes; you also benefit from the appreciation of the property. In addition, you can enjoy a steady income from the regular distributions. These values can be comparable to the dividends you earn from the shares.
You can keep owning units in an UPREIT right until the moment of death. After that, the units transfer to your chosen heirs on a step-up basis. This exit strategy is particularly useful for those who are doing their estate planning. As we mentioned, the step-up in basis means heirs can inherit the units at their current market value, potentially eliminating the deferred capital gains tax liability. You can rest easy knowing that your heirs can potentially get the maximum amount of your wealth upon your demise.
If you do plan to eventually convert your OP units to shares, it’s important to have a strategy that helps manage tax liability. One approach is to convert units in stages over several years. This practice aims to ease your tax burden, so you won’t have to pay a one-time lump sum. Another popular method is converting during a year of lower income. You might be in a lower tax bracket in such a scenario, so the capital gains tax rate would be lower.
A 721 Exchange or UPREIT is one alternative investment vehicle that lets you sell your property to a REIT in exchange for OP units. You remove the burden of active management, defer taxes, and access income from institutional-grade assets managed by the REIT. Only when you convert your units to shares are you required to pay capital gains taxes. Thanks to these benefits and opportunities, many investors who do not qualify for 1031 Exchanges opt for this approach instead.
UPREITs are still a complex process, and there are risks associated that you must take into consideration before you join a REIT. The best practice is to work with experts like us at Realized 1031. We provide insightful advice and other investment solutions to help you decide whether or not a 721 Exchange is the ideal investment vehicle for your needs. Contact us today to schedule a consultation.
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.
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