A 721 UPREIT exchange (also called a 721 transfer) allows investors to exchange their real estate property for operating partnership (OP) units in a REIT. As long as the OP units are held, taxable gains on the property are deferred. When the time comes, OP units can be exchanged for REIT shares. This terminates the tax deferment and creates a taxable event. We’ll walk through how the conversion process works.
Property Conversion Into OP Units
A UPREIT involves a property owner exchanging their property for OP units in a REIT. The REIT manager will decide on a value for the property. Then the property owner will receive OP units that are equivalent in value to their property.
OP units are similar to REIT shares and have most of their benefits. OP units also fluctuate in value, just like REIT shares.
While holding OP units, the property owner can also receive distributions from the REIT’s income. REITs must distribute 90% of their income. This distribution is usually the same amount that REIT share owners receive. Distributions are based on pro rata.
It is up to the REIT manager to accept the investor’s property into the REIT. The manager must ensure the property is a right fit for the REIT.
While REIT shares do have voting rights, OP units do not. OP unit holders own interest in the operating partnership, not the REIT.
Additionally, OP unit holders must file tax returns in each state the property is held. Technically, it is in each state they receive a K-1. But K-1s are generated based on the state the property is held. REIT shareholders do not have to make such filings.
OP Unit Conversion Into Shares
Converting OP units into REIT shares is a taxable event. Any taxable gains that an investor was deferring by holding OP units come due once those units are converted into shares.
Converting OP units into shares is a straightforward process. Investors should check the agreement they signed before attempting to convert OP units into shares. There may be a required holding period before any conversion can take place.
Once OP units are converted, a taxable event is triggered. Investors will have K-1s related to property holdings, which can be used for their tax filings.
After conversion, REIT shares can be sold immediately if desired. This is not likely to result in much if any, taxable gain.
Additionally, investors can sell their OP units for cash, depending on the partnership agreement. This also creates a taxable event.
When deciding on a 721 UPREIT exchange, it’s best to speak with an experienced real estate broker familiar with the OP unit to share conversion. Additionally, you should consult with your tax professional.
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.
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.
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.
