An Alternative Tax-Deferral Strategy for Passive Commercial Real Estate Investors
Posted on September 14, 2021
Tax-Deferral Strategies for Commercial Real Estate Investors
Commercial real property investors have long relied on Section 1031 of the Internal Revenue Code to defer capital gains tax on the sale of appreciated property when they reinvest sales proceeds into similar like-kind property. However, with the Biden administration’s proposal to restrict the tax-deferral benefits of 1031 exchanges to gains of $500,000 or less ($1 million or less for married taxpayers filing joint returns), many investors may need to rethink their existing real estate investment exit strategies. One option to consider is a transaction with an Umbrella Partnership Real Estate Investment Trust (UPREIT) to accomplish what is sometimes referred to as a Section 721 or an UPREIT exchange.
An UPREIT is a structure in which a REIT owns its properties and conducts operations indirectly through an umbrella operating partnership (OP), which is majority owned and controlled by the REIT. The UPREIT structure has existed since the early 1990s and has become very common among publicly traded REITs. One of the most unique features of this type of structure is that, if properly planned and implemented, it allows real estate investors and private real estate companies that own commercial real estate to leverage Section 721 of the Internal Revenue Code and divest themselves of real property and continue generating passive income without triggering current capital gain tax liabilities or depreciation recapture taxes.
Generally, the sale or contribution of commercial property to a REIT in exchange for money or shares of REIT stock would be considered a taxable event. Section 721 provides an exception to this rule, allowing property owners to avoid recognizing an immediate gain or loss when they contribute their ownership interest in a property to an operating partnership of an UPREIT in exchange for operating partnership units (OP Units), which are economically equivalent to and ultimately convertible into REIT stock. As a result, investors who contribute their property interests to the OP may defer capital gains tax liabilities until the point in time that they either redeem their OP units for cash, convert them to shares of REIT stock or until the operating partnership sells the contributed property. With this in mind, property contributors may carefully plan out the timing of their conversions of OP units to REIT shares so that they may spread out their related tax liabilities over multiple years. Should investors pass away before converting their OP units, they may transfer those OP interests to their heirs who would receive a step-up in tax basis that could potentially eliminate tax on any pre-contribution gains as well appreciation of OP units prior to death.
UPREIT Benefits Beyond Tax Deferral
The use of an UPREIT in a Section 721 exchange can provide commercial property owners with much more than a tax-advantaged exit strategy for disposing of appreciated commercial real estate. When compared to a 1031 exchange, they eliminate certain time restraints property owners must meet to find replacement property and complete the 1031 exchange. They also provide investors in need of immediate capital with a far more liquid asset than a direct ownership in commercial real estate, which can take significant time and effort to buy and sell.
UPREIT transactions offer investors access to the public equity markets and an opportunity to further diversify or completely change their existing real estate holdings to include multiple properties across a broader range of asset classes and geographic locations. This diversification also helps property owners mitigate their losses should any one property decline in value or fail to perform as expected.
Moreover, contributing property to an UPREIT relieves prior owners of all the time, costs and responsibilities that typically come with managing the day-to-day operations of commercial real estate. Instead, these activities will be handled by the REIT allowing original owners to essentially sit back and reap the rewards of real estate ownership, including long-term property appreciation, depreciation deductions and passive income.
Despite all the potential benefits of UPREIT exchanges, taxpayers must be careful to understand all the nuances and risks that come with these transactions, including loss of control and voting rights over the properties in the REIT portfolio and daily exposure to the volatility of the public equity markets. UPREIT transactions are also highly complex and must be structured and negotiated carefully in order to help investors avoid multiple pitfalls that could result in unexpected gain-triggering events in the future. To mitigate these risks, taxpayers looking to exit a property should meet with CPAs and tax advisors with deep experience in commercial real estate and UPREIT transaction planning.
About the Author: Arkadiy (Eric) Green, CPA, is a director of Tax Services with Berkowitz Pollack Brant Advisors and CPAs, where he works with real estate companies, commercial and residential developers, property management companies, real estate investors and high-net-worth individuals to structure investments and complex transactions for maximum tax efficiency. He can be reached at the CPA firm’s Boca Raton, Fla., office at (561) 361-2000 or via email at firstname.lastname@example.org.