Real estate investors always seek opportunities to build, diversify, and maximize their property portfolios. One increasingly popular but complex structure – the UPREIT or umbrella partnership real estate investment trust – offers unique tax incentives for contributing property in exchange for ownership shares.
But UPREITs require navigating intricate partnership agreements and tax considerations.
This guide will provide an in-depth look at:
- The hybrid structure of UPREITs
- Tax implications and treatment of property contributions
- Key motivations and benefits of UPREITs
- Process of forming and operating a UPREIT
- Risks and challenges involved
- Actions for finance and accounting professionals
The Unique Structure of UPREITs
UPREITs are specialty REITs (real estate investment trusts) structured as a partnership between an umbrella partnership (UP) and a standard REIT. This hybrid model allows tax-deferred property contributions from owners per IRC Section 721.
Here is how it works:
Property owners transfer assets to the UP partnership and receive limited partnership units equivalent in value to the property’s fair market value. This exchange qualifies as a tax-deferred contribution under Section 721. No capital gains tax is triggered.
The umbrella partnership takes ownership of the property and adds it to UPREIT’s overall real estate portfolio under centralized REIT management.
The contributing partner receives periodic distributions akin to REIT dividends based on their share of UPREIT units. Unit redemption is also possible in the future.
The umbrella partnership agreement governs the terms for partners based on their unit holdings. Agreements outline distribution policies, redemption options, capital calls, and other factors.
In essence, UPREITs incentivize property owners to contribute assets in exchange for ownership units and deferred taxes. The REIT consolidates and professionally manages the real estate using its institutional platforms and lower cost of capital.
Tax Implications of UPREIT Property Contributions
UPREITs fundamentally provide tax relief and deferral for contributing property holders through Section 721 tax-deferred exchange treatment. Here are the key tax considerations:
- Exchanging property for UPREIT units allows deferring capital gains that would otherwise be realized from an outright sale based on IRC Section 721. No capital gains tax is owed at the time of the exchange.
- Tax obligations only arise later if partnership units are redeemed for cash or REIT shares.
- Contributions are structured at the property’s fair market value, so no partial sale generally takes place. This avoids partial gains recognition.
- UPREIT units receive a carryover basis from the contributed property. Built-in gains are preserved for future recognition.
- Even property subject to depreciation recapture and ordinary gain can qualify for tax deferral through UPREIT ownership units.
- Once the UPREIT owns properties, they face standard REIT rules. At least 75% of assets must be in real estate, with 90% of income derived from rents or real estate interests to avoid corporate taxation.
- Properly orchestrating UPREIT property contributions yields major tax incentives. But the deferral period eventually ends when units are redeemed.
Benefits and Motivations of UPREITs
UPREITs uniquely align incentives between contributing property holders seeking liquidity and diversification and the REIT operator needing accretive acquisitions.
For Real Estate Property Owners:
- Tax Deferral: Delay capital gains recognition by accepting units instead of cash sale proceeds.
- Diversification: Exchange into a larger institutional portfolio rather than concentrated holdings.
- Liquidity: Units remain marketable and redeemable for cash in the future, providing liquidity.
- Estate Planning: Transferring interests to heirs is easier with diversified units versus whole properties.
For UPREIT/REIT Operators:
- Accretive Acquisitions: Grow portfolio without large cash outlays by issuing units to contributors.
- Alignment: Units provide incentives for owners, ensuring a consistent property pipeline.
- Diversification: Less concentrated risk with differing property types, markets, and tenants.
- Professional Management: Enhanced property management and leasing capabilities as a REIT.
- Lower Cost of Capital: REIT access to financing and the ability to retain cash flow benefits unitholders.
The win-win motives provide a strong upside to exploring UPREITs as an acquisition and diversification vehicle. But the partnerships add complexity.
Risks and Challenges of UPREIT Structures
Despite unique advantages, UPREITs also come with real risks and complexities, such as:
- Market Risks – Geographic concentration, tenant defaults, and changing demand for property types all impact performance like any portfolio.
- Operational Risks – No guarantee of mismanagement, even with REIT status. It must still be managed wisely.
- Conflicts of Interest – Partners may clash over distribution policies, property decisions, redemptions, etc. if interests diverge.
- Financing Risks – Unexpected rate hikes or tight lending conditions challenge REITs’ reliance on leverage.
- Portfolio Risks – If favored property sectors suffer downturns, large sector concentrations magnify losses.
- Liquidity Risks – Must maintain an active, open trading market for partnership units. Limited redemption windows help provide liquidity.
The sophisticated UPREIT structure magnifies risks compared to traditional REITs. Investors evaluate added risks against the tax advantage tradeoffs.
Actions for Finance and Accounting Professionals
For clients exploring UPREITs as owners or operators, finance and accounting advisors play a crucial role:
- Evaluate Structures – Compare benefits, costs, and risks versus a property sale, 1031 exchange, or holding status quo.
- Consult on Formation – Provide diligence on property valuations, fundraising costs/projections, REIT registration, and compliance.
- Review Agreements – Vet partnership agreements governing distributions, capital calls, and property decisions to align stakeholder incentives and prevent conflicts.
- Oversee Operations – Institute best practices for asset management, financing strategies, partner communications, and distributions.
- Guide Compliance – Coordinate annual REIT testing. Issue K-1s to unit holders. Ensure adherence to IRC rules.
- Analyze Tax Impacts – Model deferred gains recognition. Project redemptions triggering gains. Maximize deferral through swap exchanges.
With intricate tax, legal, and operating considerations, UPREITs demand diligent guidance from advisors at every stage.
The Bottom Line
UPREITs offer real estate owners unique opportunities to contribute properties tax-deferred in exchange for units in a larger diversified REIT portfolio. Significant tax deferral results from structuring contributions as IRC Section 721 partnerships.
However, the hybrid model requires navigating legal agreements governing partnership unit distributions, redemption, and property acquisition decisions. Risks like conflicts of interest, market changes, and operational challenges always remain.
Thorough diligence on the economics, tax planning, and partnership structure is essential before forming or contributing to a UPREIT.
Contact Cendrowski Corporate Advisors
If you are considering UPREITs and need expert guidance on navigating legal agreements, understanding tax implications, and conducting thorough diligence, consider reaching out to Cendrowski Corporate Advisors.
As innovators in developing Real Estate Investment Trust (REIT) and Umbrella Partnership Real Estate Investment Trusts (UPREIT) investment structures, our team specializes in providing comprehensive support for real estate owners. Contact us today to discuss how we can help you make informed decisions and maximize the benefits of UPREITs for your real estate portfolio.