Natural disasters are in the news. Hurricane-generated massive floods destroyed inland towns, while snow and ice storms wreaked havoc on Sun Belt states. At the same time, wildfires in Los Angeles have meant billions in losses.
The growing number of climate change hazards is encouraging property owners to reconsider their long-term investment strategies, with diversification being among the goals.
If you’re in this position, one possible approach is to use a 721 exchange–or Umbrella Partnership Real Estate Investment Trust (UPREIT)–to build a robust portfolio that could reduce risks inherent in natural disasters.
What is a UPREIT?
An UPREIT allows you to contribute your real estate assets to a real estate investment trust (REIT) partnership in exchange for operating partnership (OP) units. Depending on the terms, the units can be converted into cash or shares of the REIT, at which point the transaction may become taxable.
This approach can offer advantages including:
- Potential tax deferral: When you exchange your property for OP units, you could defer capital gains taxes that might otherwise be triggered if you sold the property outright. However, when you eventually convert OP units into REIT shares or cash, the deferred gain becomes taxable, potentially at higher tax rates in the future.
- Greater liquidity: Traditional real estate investments are generally considered illiquid because selling property requires a lengthy process. A 721 exchange offers the potential for greater liquidity by allowing property owners to exchange their real estate for Operating Partnership (OP) units, which may later be converted into cash or publicly traded REIT shares.
- More diversity: Rather than owning a single real estate property, involvement with an UPREIT exposes you to a diversified portfolio managed by the REIT. Furthermore, you can access professionally managed, institutional-grade assets that might otherwise be difficult to acquire independently.
UPREIT Considerations
The UPREIT process can offer many benefits but might not be suitable for every investor due to the following factors:
- Property desirability: Not every REIT will be interested in taking on your property. You might have to conduct a great deal of research to find an entity willing to trade your property for OP units. Even after spending that time, you might not be successful.
- Asset valuation: Understanding your property’s valuation is critical when using the 721 exchange. Work with experienced appraisers and advisors to ensure you receive a fair value for the asset.
- Liquidity timelines: UPREITs offer a higher degree of liquidity versus direct property ownership. However, your ability to convert OP units into REIT shares or cash might be subject to certain restrictions or lock-up periods (e.g., one to two years).
- Market performance: UPREITS are tied to the performance of their underlying REITs and the value of OP units generally reflects the financial health of the REIT. However, OP units are not publicly traded and may be subject to restrictions on conversion and liquidity. If the REITs underperform, this could impact the value of your OP units or REIT shares. Before embarking on a 721 exchange, evaluate the underlying REIT’s track record dividend history, debt levels, and market outlook.
UPREITs as a Natural Disaster Hedge
The UPREIT process can be a workable solution if you want to protect your portfolio in the face of natural disasters and uncertainty. A 721 exchange can help you reduce risk through more diverse holdings when used correctly.
However, like any investment strategy, participating in a UPREIT requires careful consideration and due diligence. Consult with real estate advisors, tax professionals and financial planners to determine if this approach aligns with your financial 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.
