Contributing property to an umbrella partnership real estate investment trust (UPREIT) allows you, as an investor, to own operating partnership (OP) units. This transaction also results in the nonrecognition of gains and losses, so you defer capital gains taxes as long as you hold the OP units. However, liquidity needs may change, and you may need to convert your OP units to REIT shares so you can later sell them.
What are the tax implications of this UPREIT conversion? Realized 1031 discusses the effects in this article, as well as strategies you can employ to manage tax liability.
You initially acquire OP units during the 721 exchange. The units you receive are proportional to the value of the contributed real estate asset. In addition, the OP units are the economic equivalent of REIT shares, allowing you to earn dividends regularly distributed by the UPREIT.
After a holding period, which is usually one year, you’re allowed to begin converting OP units to REIT shares. Since both interests are economically equal, the conversion is usually on a one-to-one basis. When you exchange OP units for REIT shares, the IRS treats this as a sale of your property interest. This means that deferred capital gains from your previous property are finally recognized, plus any appreciation of the OP units.
Converting OP units into REIT shares has several key tax consequences.
As we mentioned, OP unit conversion triggers the immediate recognition of deferred capital gains taxes from the original property you contributed. Any amount beyond the carryover basis (before the contribution) will be considered a capital gain.
Any depreciation taken during ownership of the contributed property isn’t erased — it carries forward and is taxed at recapture rates (up to 25%) when the conversion occurs. The higher rates stem from the fact that depreciation recapture is considered ordinary income.
If you had mortgage debt on the property that was relieved during the contribution, portions of the transaction may be treated as ordinary income instead of capital gains.
Some confusion may arise between two taxable events: the conversion of OP units and the sale of REIT shares. These two are entirely different, and knowing the distinction is critical for tax management purposes. The conversion is the process we outlined above, and this triggers tax liability for the deferred capital gains taxes from the contributed property (which also includes appreciation of the OP units up to that point).
Meanwhile, the REIT share sale is the actual act of selling or trading the REIT shares. If there was a delay between the conversion and the REIT sale, the REIT may appreciate, resulting in a separate tax event for the gain.
There are a few strategies you can employ to cushion the effects of tax liability after conversion.
The ultimate strategy to avoid capital gains taxes is to hold the OP units and avoid conversion until your passing. This practice results in a step-up in basis, but you won’t be around to enjoy the benefits. While holding OP units until death is the preferred strategy for some investors, you may have changing liquidity needs that prompt conversions. To answer our question above, it depends on your personal financial and estate planning goals.
Converting OP units to REIT shares results in tax liability. Knowing how the event happens and the strategies you can use to manage the tax payments helps you make more informed decisions before you do so.
Sources:
https://www.forbes.com/sites/fredhubler/2024/01/16/get-off-the-1031-merry-go-round/
https://www.investopedia.com/terms/d/depreciationrecapture.asp