Owning and managing commercial real estate (CRE) properties requires a great deal of time, money, and know-how. If you’re a CRE owner or investor who wants to move on, you could sell your properties. However, property value appreciation can mean capital gains taxes.
Another possible solution is the Section 721 exchange, also known as an Umbrella Partnership Real Estate Investment Trust (UPREIT). When structured properly, the UPREIT process can help you dispose of cumbersome commercial real estate in exchange for possible investment diversification and capital gains tax deferral.
A UPREIT Explanation
A section 721 exchange allows you to contribute your commercial real estate to a REIT’s Operating Partnership (OP). In return, you receive operating partnership (OP) units connected with the REIT. You could hold those OP units and benefit from dividends. Or you could exchange the units for REIT shares or cash.
Exchanging your CRE through an UPREIT transaction can provide the following benefits:
Possible capital gains tax deferral. As your contribution isn’t considered a sale, it doesn’t trigger a taxable event. Taxes can be deferred until you switch to REIT shares or the REIT sells your property.
Better diversification opportunities. A section 721 exchange means you contribute one property to access a broader, professionally managed real estate portfolio.
The potential for enhanced liquidity and wealth transfer. Selling commercial real estate for cash can be difficult and time-consuming. However, OP units can be redeemed for REIT shares and sold for cash. Additionally, the OP units can be easier to pass on to future generations than actual real estate.
Limitations of a 721 Exchange
Participating in a UPREIT can help you move on from commercial real estate ownership. However, before following this path, consider these caveats:
Property value and desirability. Before you and the UPREIT sponsor agree on the transfer, you must agree on the CRE’s fair value. The REIT will conduct its own appraisal, and valuation discrepancies may affect the number of OP units you receive. Additionally, the REIT may decline properties that do not align with its portfolio strategy.
Limited management control. You’re transferring commercial real estate ownership through a UPREIT. You’re also relinquishing total control of that property. Any management, financing, or sale decisions are now the REIT’s responsibility; you have no say.
Tax consequences. Contributing your property to a REIT in exchange for OP units can help defer capital gains taxes. However, the dividends you receive are taxed at your ordinary income, capital gains, or return of capital (ROC), depending on how they are classified. Additionally, if you decide to convert those OP units into REIT shares, capital gains generated on the original property contribution are recognized as a taxable gain.
Lock-in requirements. Liquidity is one potential feature of a 721 exchange. However, that liquidity might not be immediately available, especially if the REIT issues a lock-in requirement. The REIT might want to hold your contributed property for up to a year to ensure stabilization, which can tie up your capital.
Performance. The value of your OP units depends on how well the REIT shares perform on the market. Publicly traded REITs are sensitive to investor sentiment and economic shifts, which could drive down value.
A Different Kind of Investment
A section 721 exchange can provide an exit strategy from your commercial real estate holdings while helping diversify your investment portfolio. The process could also help defer capital gains taxes on appreciated CRE assets.
However, the UPREIT process can be complex, requiring assistance from tax and legal professionals. Before entering a section 721 exchange, be sure to understand the upsides and downsides and whether the move benefits your financial objectives.
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.
