When it comes to investing, real estate is an illiquid asset. There are a few reasons for this, which include difficulty of sale, access to capital, and supply and demand fundamentals. Specifically, if you need cash immediately, selling investment real estate might not be your first, or best, choice.
But through an UPREIT process, which is supported by 26 U.S. Code § 721 – “Nonrecognition of Gain or Loss on Contribution,” it could be possible to trade your illiquid real estate asset into something that might offer a little more liquidity.
A Brief UPREIT Discussion
UPREIT stands for “Umbrella Partnership Real Estate Investment Trust.” The specific partnership is formed by a real estate investment trust (or REIT) and you, as an investor with appreciated real estate assets that the REIT might want.
Through the UPREIT procedure, you contribute that property to the REIT in exchange for operating partnership units (OP). The benefit to you is that you could defer capital gains and depreciation recapture taxes from appreciated real estate through a Section 721 exchange.
From Illiquid to Liquid
So how does the UPREIT process let you move your illiquid real estate into liquid cash? Once you have those OP units, you can convert them into common stock shares in the REIT. Once converted, you can hold those shares, knowing that if you need immediate cash, you can sell them at any time. Or you could sell them right away to improve your immediate cash position. In other cases, the REIT might sell the property you contributed, which could also provide you with cash.
Transforming illiquid real estate into liquid holdings can be an important benefit of the Section 721 exchange. But there are a few downsides to an UPREIT transaction:
- Tax triggers. The moment you convert your OP units into REIT shares, you trigger a taxable event. Specifically, you’ll owe taxes on capital gains and depreciation recapture.
- Lack of demand. One challenge in using the 721 exchange to improve liquidity is finding a REIT that both wants your appreciated property, and that is willing to form a partnership to receive that asset. Finding the right REIT requires a great deal of research and due diligence.
- Volatile stock markets. Once you have converted your OP units into REIT shares, you could be ready to sell. The problem, however, is that the public markets might not be cooperative. As a result, you could end up selling those shares at a lesser price than the value of the appreciated real estate you contributed to the REIT.
Is the UPREIT Worth It?
Contributing your appreciated real estate to a REIT through the UPREIT process can help convert an illiquid asset into one that can provide you with quicker cash. But the success of a 721 exchange means finding a REIT that is willing to take your property. There are also other issues, including loss of control over the property and federal and state tax filing requirements. Finally, both selling your appreciated property or exchanging your property through an UPREIT will eventually trigger taxable events.
The takeaway here is that there are pros and cons to creating liquidity through the UPREIT process. But because UPREITs can be complex, be sure to consult with an expert before starting the exchange.
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.
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.
Holdings will generally be illiquid until which time they are converted to OP units. Even after exchanging into the OP units, repurchase of the OP units by the REIT Sponsor is at their discretion via their share repurchase plan which may be modified, suspended or terminated by the board of directors of the REIT at any time.
A REIT is a security that sells like a stock on the major exchanges and invests in real estate directly, either through properties or mortgages.
REITs receive special tax considerations and typically offer investors high yields, as well as a highly liquid method of investing in real estate.
There are risks associated with these types of investments and include but are not limited to the following:
- Typically, no secondary market exists for the security listed above.
- Potential difficulty discerning between routine interest payments and principal repayment.
- Redemption price of a REIT may be worth more or less than the original price paid.
- Value of the shares in the trust will fluctuate with the portfolio of underlying real estate.
- There is no guarantee you will receive any income.
- Involves risks such as refinancing in the real estate industry, interest rates, availability of mortgage funds, operating expenses, cost of insurance, lease terminations, potential economic and regulatory changes.
This is neither an offer to sell nor a solicitation or an offer to buy the securities described herein. The offering is made only by the Prospectus.
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.
