If it feels like you have been seeing the acronym UPREIT (Umbrella Partnership Real Estate Investment Trust) popping up frequently recently, you are correct. Sponsors and investment advisors have been touting UPREITs as a tax-deferred alternative to 1031 Exchanges.

Section 721 is one of the most common provisions in the tax code and is triggered whenever property is contributed to a partnership. This mundane provision becomes much more interesting in the context of an OP (operation partnership) transaction with a REIT. These transactions have many names: an OP transaction, UPREIT transaction, or Section 721 Exchange. In this article, we will be using the name UPREIT.

Here at Income Property Advisors, we have been getting calls from DST property sponsors in the multifamily, self-storage, and industrial sectors asking for our advice on offering UPREITs. We have been involved in UPREIT transactions in the past and have investors who have chosen this route, so we are well-versed on the subject.

Since UPREITs are very relevant currently, this is a deep dive into the subject, so you can evaluate whether they are the right choice for you.

What is an UPREIT?

An UPREIT is similar to a 1031 Exchange. It is a way for investors to defer capital gains taxes when relinquishing control of a property held for business or investment purposes. Investors are presented with the UPREIT as an alternative to exchanging into another DST (or traditional investment property) or cashing out and paying capital gains taxes.

A 1031 Exchange allows investors to defer capital gains taxes when selling an investment property by reinvesting the proceeds in a like-kind asset. Investors who choose the UPREIT option contribute their proceeds from the sale in return for investment operating units via 26 U.S. Code Sect 721 (nonrecognition of gain or loss on contribution).

In an UPREIT, the contributor’s tax basis carries over to the OP units received in exchange for the property. The gain that would be recognized by the contributors in a taxable sale is deferred until the OP sells the contributed property or the OP investors sell their OP units.

How UPREITs Work

In an UPREIT, the investor contributes property to a REIT in exchange for units in an operating partnership, which will then be converted into shares of the REIT.

In this example, Mr. X owns investment-grade real estate that Z REIT wants to acquire. The parties can arrange an UPREIT transaction as follows:

  • Mr. X contributes his real estate to the OP of Z REIT in return for OP units.
  • The OP units have a value equal to the equity value of the real estate, typically determined by MAI appraisals.
  • There is no tax to Mr. X or the OP and the tax basis carries over to his OP units. He essentially becomes a passive owner (partner of the OP). This is a tax-efficient transaction compared to a taxable sale and re-investing in real estate after tax.
  • If the real estate has a mortgage, it is common for the OP to repay or assume that mortgage and release Mr. X from that obligation.
  • The value of Mr. X’s real estate, used to determine the value of his OP interests, is computed based on the appraised fair market value less the amount of debt paid off or assumed by the OP in the transaction.

UPREIT vs. DST

Let’s now compare UPREITs and DSTs:

Management

  • UPREIT: You no longer have to worry about property management because you gain ownership in the operating partnership (OP), which provides the management.
  • DST: DSTs are already management-free.
  • Advantage: N/A

Diversification

  • UPREIT: By being in the UPREIT, you gain access to an extensive portfolio of properties within the REIT, which provides a greater diversity of real estate investments.
  • DST: DSTs allow us to cherry-pick the best properties and diversify at the same time.
  • Advantage: DSTs because with UPREITs you are stuck with whatever the REIT owns out of the approximately 1,225 REITs that exist.

Liquidity

  • UPREIT: Typically, OP units are transferable 1:1 with shares of the REIT, which would be exercised when investors are ready to cash out a portion or all of their OP shares.
  • DST: Liquidity can be an issue with a DST because there is no secondary market like there is for publicly-traded REITs. (See: DSTs & Liquidity: Can you sell a DST?)
  • Advantage: UPREIT, but the advantage is negligible. Most REITs are not publicly traded, and this benefit of liquidity will often be limited. If you own the right property, DST or sole owned, in the right market and price it right, you can mitigate the liquidity concerns.

Additional Issues with an UPREIT

Beyond these comparisons, there are several other areas of concern with an UPREIT:

  • As you can no longer complete a 1031 Exchange after contributing to an UPREIT, you will forfeit your tax advantages moving forward.
  • Upon conversion of OP units to stock (not when the stock is sold), investors must recognize their capital gains, recapture depreciation, and pay any applicable state taxes.
  • Fees and expenses are often higher for REITs than for individual properties and DSTs.
  • To be the subject of an UPREIT transaction, the property must meet the REITs’ investment criteria, which typically means investment-grade real estate, but most real estate is not investment grade.
  • There are situations where the REIT management decides to liquidate the REIT Partnership “OP” (mergers, acquisitions, etc.), forcing investors to sell.

Ultimately, contributing your DST property into an UPREIT is a case of letting the tax tail wag the dog.

Evaluating the REIT

Investors who choose to defer their taxes through the UPREIT option receive passive income, see potential growth, and can sell their units/shares in the future. However, the single most important factor is the actual REIT. These are questions to ask when evaluating a REIT:

  • Is the REIT being offered as an UPREIT a good investment?
  • Is it the best REIT available out of the approximately 1,225 REITs that exist?
  • Does it have the potential to outperform the real estate you already own?

With the DST option, we choose specific properties because we have extensively reviewed the due diligence, sponsor, and area. In doing so, we believe they have the potential to outperform other properties. However, in the case of an UPREIT, you get the good, the bad, and the ugly, including whatever properties the REIT owns.

This begs the question: why trade a well-analyzed DST property for a collection of properties that average out to mediocre?

Conclusions

In our twenty-plus years of experience with passive real estate investing, I have yet to see REITs perform as well as individual properties or DSTs. As such, my analysis as a long-term real estate investor is that you are better off giving UPREITs a miss and instead exchanging into DST properties.

If you would like to discuss the differences between UPREITs and DSTs further, contact us today to speak with one of our partners.