The two most captivating words in the real estate world may well be: tax deferral. This phrase captivates audiences and generates high interest, especially among commercial property investors. When property has enjoyed a significant jump in value and has reached its prime, owners typically seek ways to dispose of it — without paying hefty capital gains tax. Or perhaps they are too heavily invested in real estate and want to diversify.
Regardless of the reason, investors who may not benefit from a 1031 exchange have an alternative: the UPREIT, or Section 721. This innovative tool emerged a little over 25 years ago. The UPREIT is a clever mechanism that allows investors to defer capital gains and depreciation recapture taxes. While their portfolio will experience a dynamic change, it is still a practical way to participate in the real estate market; they will receive interest in a partnership while stretching the timeline to recognize taxable gains.
The Concept and Process of the UPREIT
An Umbrella Partnership Real Estate Investment Trust (UPREIT) is a partnership formed between the owner of appreciated real estate and a REIT. In this framework, accredited investors contribute property into the operating partnership, which is owned by a REIT. In return, the investor receives Operating Partnership (OP) units — or interest — in the partnership. It’s important to note that this transaction does not generate a taxable event, as no cash has actually changed hands. And the investor doesn’t acquire publicly-traded REIT stock — but only OP units. This is one feature that makes an UPREIT extremely attractive to many investors. Also, this structure, unlike the 1031 exchange — isn’t tied to a calendar; the investor can choose, at a later date, to convert all or only a portion of OP units for shares of REIT stock or cash. The owner of the REIT, or the Sponsor, is typically the one who initiates the conversion, triggering the taxable event. This structure provides flexibility as to the amount and timing of the recognition of capital gains.
The Downside of UPREIT
By now, some may be wondering: What is the catch? Can something this beneficial actually have a downside? While capital gains may be deferred for an indefinite period of time, a day of tax reckoning will eventually appear on the horizon. Once OP units are converted to stock, the scenic 1031 Exchange train ride is over; it’s the end of the line. From this point, the interest is no longer considered real property. When the REIT shares are sold — or the investor receives income from the sale of the REIT portfolio — those gains will be treated as capital gains or losses when filing an income tax return.
A few of the disadvantages are listed below:
Lack of Control. This is a glass half full scenario. The contributing investors no longer have the headache or property management woes. Think of that as a credit. On the flip side, they lose control. Once investors contribute the assets, the REIT is the new owner of the acquired property. It is now hands-off; you no longer own the real estate. All properties are indirectly and exclusively owned by the REIT. This may only be an issue for direct property owners who have relinquished property and like direct ownership.
Voting Rights. Unlike REIT investors, those who hold OP units forfeit all voting rights.
Estate Planning Considerations. Building and leaving a legacy is something nearly everyone considers; it isn’t unique to investors. Yet investors sitting on valuable assets may give more thought to estate planning, especially ones who wish to transfer their OP units to multiple heirs and other beneficiaries. A tax professional well-versed in UPREITs should be consulted prior to the death of the OP holder. For example, the estate receives a step-up in basis.
Federal and State Tax Filing Requirements. Investors who held a property in Texas, for example, were only required to file Texas taxes. REIT shareholders are also only required to file income taxes in their state of residency. Conversely, OP unit holders are subject to tax filing requirements in each state in which the operating partnership transacts business. This will result in considerable tax filing complications — again, an expert will be essential in unpacking all the tax filing nuances.
The Case of the Erratic Stock Market. OP unit holders are not immune from the volatility of the stock market; wild swings are possible. When the market is contracting, there’s no guarantee that the value of the underlying REIT shares — which are correlated to the S&P 500 if you are in a publicly-traded REIT — won’t take a dive.
The UPREIT has many advantages, but astute investors would be wise to explore the many facets of this unique tax-deferral partnership.