When executed properly, Umbrella Partnership Real Estate Investment Trusts (UPREITs) can provide a tax-advantaged diversification approach or exit strategy if you’re done with active property ownership. However, the process can be intricate and involves legal and tax issues.
If you’re considering an UPREIT approach, it’s important to understand the factors that might impact your investments. That knowledge helps determine if such a move is in your best interests.
A Brief UPREIT Overview
Also known as the section 721 exchange, the UPREIT process has three elements: a real estate investment trust (REIT), the REIT’s operating partnership (OP), and your property. These come together when you contribute your property to the REIT and receive OP units in exchange; you can convert those units into REIT shares or cash later, though this conversion is a taxable event.
An UPREIT structure’s key benefit is tax-deferral. Contributing your property–rather than selling it outright–defers capital gains taxes until OP units are exchanged for REIT shares or cash. This process can help you manage your tax obligations while offering access to various properties that can enhance portfolio diversification.
The Legal Side
While a section 721 exchange can provide multiple investment advantages, the approach comes with the following legal and tax implications.
Taxable event triggers
Contributing property to a REIT doesn’t generate capital gains or taxation requirements. However, exchanging your OP units for REIT shares can trigger tax liabilities. You could owe capital gains taxes on the appreciated property value at that time.
Additionally, if the REIT sells the contributed property, this does not necessarily result in an immediate taxable event for OP unit holders. However, converting OP units into REIT shares or cash will result in capital gains taxation based on the original property contribution.
Rights and restrictions
While OP units allow you to share in the REIT’s dividend income, you don’t have voting rights in the REIT itself. Additionally, you might be restricted for a period of time from converting your OP units into REIT shares or cash. This is called a “lock-out” or “lock-up” period, and it means you might not have immediate access to your capital.
Risks and liabilities
As with any investment, know the risks of contributing your property to a REIT through the 721 exchange process. Other risks might include a downturn in the real estate market or a REIT’s volatile stock price.
Additionally, a conflict of interest could come into play if your interests don’t match those of the REIT’s existing shareholders, especially in areas like property management or asset sales.
UPREITs and Legalities
While the UPREIT process can generate many benefits, it also comes with contractual risks, liabilities, and tax considerations. Do your homework if you’re considering using a 721 exchange as a real estate investment strategy. Research the targeted REIT and get advice from knowledgeable real estate attorneys, tax professionals, and financial advisors.
Taking the steps necessary to understand the upsides and downsides of an UPREIT can help avoid mistakes while keeping you on track to meet your investment goals.
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.
