Digging into what triggers taxes on an UPREIT (Umbrella Partnership Real Estate Investment Trust) is best approached with a foundation of understanding of the UPREIT and the REIT itself.
UPREIT and REIT Basics
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 must also 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.
When is an UPREIT taxable? UPREIT transactions generally defer taxes until certain events occur. These events include converting OP Units to REIT shares, selling or redeeming OP Units for cash, or selling the contributed property by the REIT. Taxes may still be deferred if a 1031 exchange or other tax-deferred transaction is used to sell the contributed 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 Realize the Gain — If At All.
Among the remarkable aspects of the UPREIT (often called a 721 exchange because it falls under IRC Section 721) is the taxpayer's control 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.
Estate Planning Benefits
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 UPREIT tax on capital gain or recapture of depreciation to be concerned with.
