An Umbrella Partnership Real Estate Investment Trust (UPREIT) is a partnership formed between the owner of appreciated real estate and a REIT whereby the owner of the appreciated real estate contributes the real estate assets in exchange for operating partnership units (OP units) in a tax deferred exchange similar to a 1031 exchange. The same tax deferral benefits are achieved as with a 1031 exchange.
Capital gains taxes are deferred until such time as the exchanger sells the Operating Partnership Units (or OP Units), converts the OP Units to REIT shares or the acquiring operating partnership sells the contributed property. The exchanger may receive the additional benefit of converting their interest in one or more properties into a larger property portfolio. However, an UPREIT transaction is not available to all exchangers, as the relinquished property must be an asset the REIT or operating partnership wishes to acquire.
For example, rather than an outright sale, the owner of a 300-unit apartment complex may contribute the property to a REIT, on a tax-deferred basis, in exchange for OP units in the REIT. The (former) apartment owner may then choose to convert all or a portion of her OP units at a later date for shares of REIT stock.
The conversion of OP units to stock would trigger capital gains taxes to the investor, however the investor is not required to convert all of her shares at the same time. Thus a 721 UPREIT exchange provides the advantages of timing flexibility and greater options in recognizing gains when compared to a traditional 1031 exchange.
However, a disadvantage of an UPREIT exchange compared to a traditional 1031 exchange is that once the OP units are converted to stock, the interest is no longer considered real property and thus is not eligible for additional 1031 exchanges. Also known as 721 UPREIT Exchange.