UPREIT is short for “umbrella partnership real estate investment trust,” an UPREIT is an alternative to a section 1031 like-kind exchange as a way to defer or completely avoid capital gains tax liability when an individual or company wants to sell appreciated real estate.
Instead of selling the property, the owner contributes it to an UPREIT in exchange for securities called “operating partnership units” or “limited partnership units.” The partnership units are worth the same amount as the contributed property. Unlike selling the property, this transaction doesn’t create a taxable event. UPREITs became popular in the 1990s. Most large REITs are UPREITs.
BREAKING DOWN ‘UPREIT’
Upon contributing real estate to the UPREIT, the property owner also receives a put option that allows him or her to convert his or her partnership units into REIT shares or cash after a minimum of one year. Such conversion by the contributor is could create a taxable event. However, the owner’s heirs, including a spouse, may wish to use the put option after the owner’s death. Because the partnership units’ basis is stepped up to current market value when the owner dies, the owner’s heirs can convert the partnership units to REIT shares or cash without triggering capital gains tax.
UPREITs thus allow owners to transfer appreciated property to heirs tax-free, making UPREITs a valuable tool for estate planning. UPREIT partnership units are also a more liquid source of capital than real estate to pay estate taxes upon the owner’s death.
UPREITs do have a couple of caveats:
1. If the UPREIT liquidates during the contributor’s lifetime, this event would be taxable. A standstill or lockup agreement can eliminate or minimize this risk.
2. The number of partnership units the contributor receives depends on the current market value of those units. Contributing property to an UPREIT at a time when its shares are overpriced can be a bad deal if those shares later decline in value. Contributing when shares are underpriced, however, can make the transaction even more valuable in the long run as the partnership units gain value.
Possible UPREIT benefits
UPREITs can diversify your portfolio. An investor is no longer a real estate property owner. Contributing to an UPREIT gives the owner a new stake in an entire portfolio of real estate properties and that portfolio’s income stream.
UPREITs can also provide liquidity and flexibility. Real estate property is an illiquid asset. Operating partnership units can be converted into traditional REIT shares – which can be sold or converted to cash. (As previously stated, these transactions could possibly cause a tax liability).