Property owners who are ready to cash out of their real estate investments have multiple options available to them, but each of those options comes with different tax implications.
Depending on which strategy your clients want to pursue, they may be able to divest real estate investments and minimize their exposure to taxable gains. Let’s take a closer look at five common ways investors cash out of their investment real estate holdings and the tax implications associated with each strategy.
Depending on their financial objectives, your clients likely will pursue one of the following exit strategies for their investment properties.
Since UPREITs are the least-common exit strategy among these options, let’s take a closer look at how the process works for clients who want to divest investment properties.
Investors who want to exit their commercial investment properties don’t necessarily have to find a buyer. Landlords with highly desirable and well-positioned properties may be able to find a real estate investment trust (REIT) that wants to acquire their real property assets.
Selling the property outright would trigger a taxable event, but your clients can exchange direct property ownership for an equal value of operating partnership (OP) units in the REIT that total their property’s value. Since no cash is changing hands, your clients can defer capital gains taxes. However, that deferred tax liability will come due if your clients sell their OP units, convert them into common shares of the REIT, or the REIT itself divests the property.
This strategy has pros and cons. Potential benefits can include regular dividend income and share price increases. Drawbacks may include lack of investor control, volatility since most UPREITs are publicly traded, and limited voting rights. And unlike other passive real estate investments, UPREITs are not eligible for 1031 exchange treatment upon exit.
In an UPREIT, real estate investors are swapping direct property ownership for ownership shares of the trust. Essentially, they are subbing a security for their real property. This tax-deferral strategy only works when investors find REITs that are interested in acquiring their properties.
Although your clients can eventually convert their OP units into shares of the REIT, which then can be sold like any common stock, they will generate a taxable event on any OP units they do sell. This strategy offers limited tax deferral benefits, therefore, since any increase in liquidity comes with immediate tax consequences. Your client also faces a taxable event if the UPREIT decides to sell the property; however, it’s not uncommon to include provisions in the UPREIT agreement for the trust to hold the asset for a minimum of five or more years.
Sellers who enter into UPREIT agreements have the flexibility of liquidating their OP units on a staggered basis, which spreads out their tax burden over time. They also can bequeath them to heirs of their choosing upon their death, which brings in important estate planning considerations.
Lastly, completing a 721 exchange provides a one-time deferral. Investors can alleviate the deadline pressure that often comes with traditional 1031 exchanges, but they can’t continue the exchange process indefinitely like they can with 1031 exchanges. At some point, the tax bill will come due.
Investors have multiple strategies they can pursue to cash out of their investment properties. Exchanging direct property ownership for operating share units of an umbrella partnership real estate investment trust can offer your clients some advantages over traditional 1031 exchanges, straight sales, or cash-out refinancing. UPREIT shares are securities, though, and your clients should fully understand the ramifications this exit strategy may have upon their investment and tax planning strategies.
Full disclosure. The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.