Investors have plenty of choices when it comes to the type of investment approach they take, particularly in the real estate sector. However, various options offer similar benefits, and some are so closely structured that confusion arises. Things can get complicated! Real estate investment trusts (REITs) and umbrella partnership real estate investment trusts (UPREITs) are two prominent examples.
These two investment vehicles both own underlying properties and generate income for interest holders. However, there are a few key distinctions between the advantages they offer and their ownership structures that make a world of difference. What is an UPREIT, and how does it differ from a traditional REIT? Realized 1031 is here to share all you need to know.
A REIT is a company and legal entity that owns, operates, and finances income-generating real estate assets. This structure removes responsibility and direct ownership for investors. Instead, they enter the REIT by purchasing REIT shares, which is akin to buying stocks. This way, an investor can gain exposure to the real estate market while avoiding the burden of active management.
There are three popular types of REITs today.
There are a few rules that govern the operations of REITs. Among the most well-known is the 90% rule, which requires REITs to distribute at least 90% of their income to shareholders. This feature makes REITS appealing to investors focused on steady cash flow.
UPREITs work similarly to REITs, which is unsurprising since REITs are a component of the former. What’s the difference? An UPREIT is a larger operating partnership (OP) composed of the REIT and the investors. You can become part of the UPREIT by contributing your assets to the OP in exchange for OP units. These units are the economic equivalent of REIT shares.
In this structure, the REIT has the controlling interest, and you’re a limited partner. As the underlying properties earn income, the REIT distributes dividends to each investor depending on the number of units they own.
What’s the point of creating an operating partnership? Contributing your assets to an operating partnership and receiving OP units is known as the 721 exchange, which could potentially allow you to defer capital gains taxes. The IRS doesn’t recognize gain or loss during this exchange, so you can delay tax liability and preserve more of your wealth. Unlike receiving REIT shares, which can trigger an immediate taxable event, OP units allow you to maintain your investment without incurring taxes in the year of the transaction.
Here are some of the definitive differences between these two types of investments.
UPREITs offer unique advantages that you may not encounter with REITs and other types of investments.
The main benefit of UPREITs is the tax deferral. This advantage is especially appealing to those nearing retirement who have highly appreciated properties. Contributing their assets to the UPREIT allows them to preserve more of their retirement funds and avoid major tax hits.
Both REITs and UPREITs remove direct control of properties from investors. Those who no longer want the burden of direct management over their properties will find this benefit a major advantage.
Many UPREITs own multiple properties across various geographic locations. While some specialize in sectors like multifamily housing or retail, there are others that hold assets from several sectors. These features help diversify your portfolio and provide additional cushion against market downturns.
REITs are usually established companies with experts and systems that allow them to expertly handle the operations and management of the UPREIT. Direct ownership won’t provide such an advantage.
If you hold your OP units until your passing, they undergo a step-up in basis that resets their cost basis to their fair market value upon your death. Thanks to this benefit, your heirs can enjoy some tax relief. Shares from traditional units also undergo a step-up in basis, but since they don’t carry the deferred capital gains as OP units do, the reduced tax isn’t as substantial.
What are some of the challenges and possible pitfalls associated with UPREITs? Here are some of what you should watch out for.
Here are a few scenarios where UPREITs are an ideal avenue for investors.
In summary, a REIT is a legal entity that owns real estate assets, while UPREITs are operating partnerships controlled by REITs. Tax deferral is the main benefit of UPREITs that you don’t encounter in traditional REITs, making the former popular for investors who want to preserve their capital for longer.
Regardless of the method you choose to invest in, in-depth research and professional guidance remain essential. With sufficient knowledge, you can confidently enter either option and increase the chances of maximum ROI.
Sources:
https://www.investopedia.com/terms/u/upreit.asp