Digging into the great question of what triggers tax on an UPREIT (Umbrella Partnership Real Estate Investment Trust) is best approached with a foundation of understanding of both the UPREIT and the REIT itself.
A REIT, or Real Estate Investment Trust, is a trust that invests in real estate or real estate-related assets. REITs allow people to invest in real property portfolios or large properties similar to how they buy stocks. As long as a REIT has at least 75% of its total assets in real estate and earns 75% of its earnings from real estate-related activities, it qualifies as a pass-through entity and avoids federal income tax at the corporate level. A REIT must also have at least 100 shareholders and not have more than half of the ownership concentrated in less than five individual investors' hands. REITs are also required to distribute at least 90% of taxable income to shareholders as dividends.
An UPREIT is a partnership between the owner of real estate and a REIT. The real estate owner exchanges his asset for operating partnership units (OP units) in a transaction similar to a 1031 exchange, receiving the same deferral of tax recognition on the capital gain enjoyed by the subject property. That deferral is valid until one of the following takes place:
- The taxpayer sells the Operating Partnership units,
- The taxpayer converts the units to shares in the REIT, or
- The REIT sells the subject property.
The property for share exchange is allowed by IRC 721, and the transaction into the 721 UPREIT allows the same tax-deferral benefit that the investor can achieve with a 1031 exchange. However, the target property must be one that the REIT wants to add to its portfolio, which may be a limiting factor in some circumstances. Just as finding the right buyer for a 1031 exchange can delay the transaction, finding an interested REIT to acquire the asset could be an obstacle for an investor. If the REIT later decides to sell the acquired property, this will trigger the taxable event the investor was seeking to defer.
The taxpayer chooses when to realized the gain--if at all.
Among the remarkable aspects of the UPREIT (often referred to as a 721 exchange because they fall under IRC Section 721) is the control the taxpayer maintains over timing. The investor who partners with the REIT decides when to convert the OP units into REIT shares, in agreement with the REIT management. This conversion triggers the realization of capital gains taxation and allows the taxpayer to parse the gain out in smaller amounts or pair it with a well-timed loss.
Benefit for estate planning
Transitioning from direct ownership into an UPREIT may be an excellent path when the investor plans their estate. If the investor converts property into an UPREIT, they will defer the capital gain taxes on the appreciated property and receive the income from dividends that the REIT produces.
After the investor's passing, the heirs receive the Operating Partnership units to liquidate or keep. Since they benefit from the step-up in basis, there is no tax on capital gain or recapture of depreciation to be concerned with.