What is an UPREIT?

What is an UPREIT?

Posted by on Feb 8, 2021

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Real estate investment trusts (REITs) were established by Congress in 1960 to give investors access to real estate. REITs enabled smaller investors to pursue the benefits of commercial real estate investment. As REITs evolved, different structures came into play — one of these being the UPREIT, which was first developed in the early 1990s. 

What is an UPREIT?

An umbrella partnership real estate investment trust, or UPREIT, is a partnership formed between the owner of appreciated real estate and a REIT where the owner of the appreciated real estate contributes real estate assets in exchange for operating partnership units (OP Units) in a tax-deferred exchange. An UPREIT is any REIT that qualifies for a 721 exchange.

This exchange is known as a Section 721 exchange, which defers capital gains taxes with the same benefits similar to a 1031 exchange. Capital gains taxes are deferred until the exchanger sells the OP Units, converts the OP Units to REIT shares, or the acquiring operating partnership sells the contributed property. 

This is possible because no cash is received in the sale, and the investor doesn’t acquire publicly-traded REIT stock. There’s also greater flexibility with a Section 721 exchange as there is no strict timeline that the investor must follow to qualify 一 like with the 1031 exchange. UPREIT transaction structures are governed by IRC Section 721, which examines tax shields for property to share exchanges. 

UPREIT Advantages

UPREITs can provide several potential benefits for investors that aren’t accessible through conventional real estate transactions:

  • Liquidity: While real estate is typically a very illiquid asset, if an UPREIT investor needs money, some or all of the OP Units can be converted into shares of a REIT, which can be sold. However, this does create a taxable gain. 
  • Passive investing: Investors can take advantage of passive investment with no property management duties.
  • Tax advantages: When appreciated real estate is sold, the investor can avoid capital gains tax liability.
  • Potential income: Although cash flow through a rental property can fluctuate, REITs usually pay dividends.
  • Diversification: An UPREIT allows investors to hold an interest in a REIT. Adding diversification to your portfolio can help manage risk. 
  • Estate planning: OP Units can be transferred to heirs or beneficiaries upon death on a stepped-up basis. Once transferred, heirs can receive dividends and benefit from the elimination of capital gains tax unless the units are converted into REIT shares. 

UPREIT Disadvantages

Considering all the benefits, it’s difficult to imagine that there can be a downside. We’ve previously covered the disadvantages of an UPREIT if you want a more in-depth look. 

Here are a few possible disadvantages:

  • Limited voting rights: Voting rights associated with OP Units are limited and would apply only to matters that affect the rights of the holders, such as distributions, redemptions, and tax allocations.
  • Lack of control: While it may be an advantage to hand over the responsibilities associated with property management, some may prefer the control that comes with direct ownership. Once assets are contributed, the REIT is the owner of the property.
  • Filing requirements: Per federal and state tax filing requirements, REIT shareholders are required to file income taxes in their state of residency, and OP unitholders are required to file taxes in each state in which the operating partnership transacts business. Additional guidance from an expert is highly advised. 
  • Volatility: Shares can fluctuate based on management, valuation of the property, financing deals, or other transactions. Although due to its liquidity, shareholders can quickly exchange shares for cash.

An UPREIT may be able to provide real estate investors with many potential benefits, especially smaller investors who wish to pursue everything UPREITs have to offer. Investors interested in an UPREIT should first consult a 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.

Diversification does not guarantee a profit or protect against a loss in a declining market. It is a method used to help manage investment risk.

 


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