In a tight real estate market with low inventory, investors may need a 1031 exchange alternative. If a seller wants to defer taxes but available properties don’t fit within their criteria, a traditional 1031 exchange may not make sense. This can be especially true in today’s current market. The good news is that a seller still has several options available outside of a traditional 1031 exchange.
One option that may make sense for some sellers is an UPREIT, which stands for Umbrella Partnership Real Estate Investment Trust. This term is a mouthful and might sound complicated but the process is actually fairly simple. Before we dive into UPREITS it is important to understand how a REIT or Real Estate Investment Trust functions.
What is a REIT?
A real estate investment trust or REIT is a company that holds a portfolio of income-producing properties. REITs can hold a variety of asset classes within commercial real estate from retail shopping centers to medical facilities, office, multifamily, and even industrial and data center. The company, or REIT, pays out income to its shareholders in the form of dividends.
REITs are accessible to virtually everyone. Similar to buying a stock or mutual fund, an investor can purchase shares of a REIT through the individual company stock or through an exchange-traded fund. This allows almost anyone to benefit from the income of commercial real estate without having significant cash, risk, or time involved.
A REIT can be publicly traded or privately held but is generally professionally managed with the purpose of maximizing income to the company’s shareholders. An investor looking to purchase shares in a REIT will have plenty of options as publicly traded REITS currently own over $3 Trillion in assets.
REITS and Capital Gains
So how can a property owner looking to sell take advantage of a REIT and defer capital gains? The seller of the real estate can exchange their property into a REIT by exchanging for shares or “units” of the REIT worth the value of the property they currently hold. This is called an UPREIT.
As an example, if a seller owns a commercial, income-producing property valued at $5MM, that owner could perform a section 721 exchange into an REIT and will receive $5MM in dividend-paying units of that REIT. This “property-for-shares” exchange is permitted under the Internal Revenue Code (IRC) 721, which governs how an UPREIT can be performed. Because the seller is trading the property for the equal value of REIT units, a taxable event does not occur.
Nuances to REITS
- Units of the REIT may come in the form of shares, or held by the seller for a minimum of one year before being automatically converted to cash.
- Any individual REIT typically holds one specific asset type that they specialize in. Identifying the right REIT for commercial property is crucial to executing an UPREIT.
- The IRC does not allow 1031 exchanges with REITS since the “property-for-shares” exchange is not considered a “like-kind” exchange, which is required to complete a 1031. Although they both function as a way to defer capital gains, they are different processes under the IRC.
- Just like in a 1031, there is an intermediary that handles the “exchange”. In the case of an UPREIT, the intermediary is the Operating Partnership of the REIT.
Advantages of UPREITS
- Sellers can defer capital gains
- They offer a passive investment solution
- UPREITS are highly liquid investments, as shares can be sold and converted to cash.
The downside is that as a shareholder and not a property owner you lose some of the tax benefits such as depreciation and lose any decision-making role as a passive shareholder.
An UPREIT may make sense for some sellers, particularly those who do not want to continue owning and managing commercial properties. It is also a good solution in a tight market where the seller can not find an acceptable 1031 exchange.
If you are interested in the benefits of an UPREIT and want to explore an UPREIT further, contact a SterlingCRE Advisor today.