If you own appreciated-value investment real estate, an Umbrella Partnership Real Estate Investment Trust (UPREIT) can be a good tax-advantaged option. Available through the Internal Revenue Code (IRC) Section 721, a UPREIT transaction allows you to trade your real estate assets in exchange for Operating Partnership (OP) units in a real estate investment trust (REIT). Those units can be exchanged for REIT shares or cash at a later date.
In addition to potential tax deferral benefits, a successful UPREIT can provide real estate diversification and liquidity. However, not all REITs are alike. Before embarking on a Section 721 exchange, conducting due diligence on the UPREIT sponsor to which you’re entrusting your investment real estate is important.
Researching the UPREIT Sponsor
The UPREIT sponsor is actually the REIT that owns a controlling interest in the Operating Partnership (OP), which manages the trust’s real estate portfolio. The sponsor also provides information about exchanging real estate assets for OP units and how long you must hold those units before converting them into REIT shares or cash.
The success of your UPREIT investment depends on several factors, including the sponsor’s ability, financial strength, and market presence. Poor management or adverse market conditions could impact your income distribution or asset growth.
When analyzing the UPREIT sponsor, consider the following:
- Financial information: Examine the sponsor’s balance sheet, income statement, and cash flow statement. Monitor metrics, including Funds from Operations (FFO), debt-to-equity ratios, and Net Asset Value (NAV). Also, focus on rental income, operating costs, and capital expenses. These and other data determine the REIT’s financial health.
- Property valuations: The value of your property or properties determines the number of OP units you receive. This has a direct impact on your equity position and income potential. Also, be aware that the value of your contributed property could be diluted if the UPREIT sponsor decides to issue additional OP units or REIT shares to finance new acquisitions or other activities.
- Compliance with regulations: You want to ensure that the REIT complies with IRC Section 856. The requirements include that at least 75% of the REIT’s income comes from real estate. Furthermore, the REIT must distribute at least 90% of its taxable income (generally through dividends).
Understanding the Risks
In addition to performing due diligence on your targeted UPREIT sponsor, also think about other Section 721 exchange limitations like:
- Loss of control: When you exchange your investment property through a UPREIT, you cease to control what happens to that asset. Asset management, capital expenditures, and disposition are the responsibility of the REIT.
- Market volatility: The value of your OP units rests on the underlying REIT’s performance. That performance, in turn, is determined by the unpredictable market. A fluctuating market could impact your investment goals and cash flow.
- Conversion pitfalls: While OP units can be exchanged for REIT shares or cash, doing so comes with tax implications. Additionally, the REIT might have a lock-in period that could prevent immediate conversion of the units.
Knowing the Benefits While Weighing Risks
Working with the right UPREIT sponsor can help you grow wealth by accessing diverse and professionally managed real estate portfolios. However, using the Section 721 exchange to trade your property for OP units requires due diligence of the REIT, its philosophy, performance, properties, and strategies.
Assembling a team of experienced tax advisors and other professionals can help you gain insight into your targeted REIT. Furthermore, working with the professionals at Realized 1031 can provide guidance on Section 721 and how to use it to meet your investment objectives.
Visit Realized 1031’s website at realized1031.com for information or to schedule a no-obligation consultation.
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.
