In a 721 exchange, or "UPREIT", an investor contributes property to a REIT in exchange for units in an operating partnership that will then be converted into shares of the REIT itself.
Due to the structure of a 721 exchange, the gains on the sale of a property will be deferred. In a typical sale, the gains that are realized as part of the sale would be subject to tax. This tax plus the tax on depreciation used to offset property taxes can sometimes exceed 25% of the gains you would receive upon sale. This leaves the investor with a substantially less amount of capital that can be used for another investment. With a 721 exchange, the investor would avoid the costly taxes and be able to use 100% of the gains on sale to purchase shares of a REIT. This strategy must be weighed against the fees that are required to complete the 721 exchange in order to purchase the REIT shares.
When an investor is preparing to pass down their assets to their next of kin, the 721 exchange is a strategy that is often used and is beneficial. Physical real estate is often difficult to sell and can lead to conflicts in the division of the assets. However, if the estate should exchange by way of 721, they will still receive all of the benefits during their lifetime, and upon passing, the shares can be split equally and either held or liquidated by the heirs of the trust. Since the shares are passed through a trust, the heirs will receive a step-up in basis and will avoid all capital gains and depreciation recapture taxes that were deferred by the estate.
REIT shareholders are passive. Managers oversee the operation of the REIT and manage its assets. This allows investors to have a hands-off approach while the managers handle the day-to-day decision-making process for the portfolio of assets. The investors receive communication about acquisitions, dispositions, and distributions, but will not be involved in any of these decisions.
Due to the 721 exchange allowing an investor to purchase shares of a REIT, there are numerous diversification benefits. Generally speaking a REIT will have properties located in many different geographic locations, as well as having tenant, industry, and sometimes asset class diversification. As a shareholder of the REIT, the investor would no longer have their interests in a single asset. The REIT will provide the similar benefits of appreciation of the Real Estate, depreciation tax shelter, and income (in the form of dividends).
Every REIT has specific acquisition criteria, and it is unlikely that the property a given individual wants to relinquish meets the criteria of the REIT the investor wants to invest in. The solution is to combine a 1031 exchange with a 721 exchange, which allows one to acquire a fractional interest in institutional grade property that meets the criteria of the REIT the investor wants to invest in.
This fractional investment must be held for a sufficient amount of time (typically around 24 months) to keep the 1031 exchange in tact. The good news is that the investment may pay dividends out to the investor throughout this period. After this point the fractional investment can be contributed to the REIT in exchange for operating partnership units based on the value of the property. These units will then be exchanged for direct ownership of shares in the REIT.
REIT shares themselves are not eligible to be used in a 1031 exchange, and therefore once a 721 exchange is completed, capital gains taxes are deferred until the investor decides to sell their shares of the REIT, or the REIT returns capital to the investors. The investors will be required to recognize any capital gain or loss when they file their taxes post selling their shares.
The term UPREIT (short for “Umbrella Partnership Real Estate Investment Trust”) refers to an entity structure that has been used by REIT’s since 1992 to allow selling property owners the ability to convert their ownership of one or more of their specific real estate properties into an interest which is‚ immediately‚ or can ultimately be converted into‚ a private or public security. In the basic UPREIT structure‚ all REIT properties are acquired and owned directly or indirectly by its “umbrella partnership.” The umbrella partnership is the entity through which the REIT operates and collects all income from the properties‚ which is why the umbrella partnership is commonly referred to as the “operating partnership.” Thus‚ the REIT does not directly own any real estate properties in the UPREIT structure‚ rather it owns substantial interests in the operating partnership by being both its sole general partner and one of its limited partners. In the case of our structure‚ AMR REIT, Inc. is the REIT and the managing member of AMR Capital‚ LLC‚ which is the “operating company” of the REIT.
The partners of the operating partnership (“OP Unit Holders”) are former property owners who took part in an “UPREIT transaction.” In an UPREIT transaction‚ property owners contribute their properties in exchange for ownership units in the operating partnership (“OP Units”).The UPREIT structure allows for UPREIT transactions‚ and UPREIT transactions provide an attractive tax deferred exit strategy for owners of real estate who will recognize a significant taxable gain in a cash sale of a highly appreciated property with a low tax basis. If real estate is sold or contributed directly to the REIT‚ it would result in a stepped-up cost basis in the property for the REIT and a taxable event for the contributing property owner. However‚ by contributing the property to the operating partnership instead of the REIT‚ the contributing property owner’s historical cost basis is maintained. Indeed‚ the primary incentive for a selling property owner in entering into an UPREIT transaction is that it can be completed on a tax deferred basis. Again‚ the owner of the property being contributed to the operating partnership does not recognize immediate gain on the transaction because the owner does not acquire shares of stock in the REIT‚ but rather receives OP Units in the REIT’s operating partnership. In addition‚ if the OP Units end up in the owner’s estate‚ the ultimate recipients of the OP Units will receive a stepped-up basis equal to the value at death and the inherent gain resulting from the UPREIT transaction will not be subject to capital gains or income tax. The tax deferral or avoidance‚ as the case may be‚ gives REIT’s utilizing the UPREIT structure a large advantage over cash purchasers of real estate. While tax deferral/avoidance may be the primary incentive to entering into an UPREIT transaction‚ there are many other great benefits for selling property owners as a result of completing an UPREIT transaction. See the “Summary of Benefits” listed below.
One of the more notable benefits of an UPREIT transaction is that‚ in becoming an OP Unit Holder‚ the property owner essentially converts an interest in one or more specific properties into an interest in a larger and more balanced portfolio of properties. The operating partnership’s portfolio is often diversified as to property type and geography‚ and usually benefits from the economies of scale and management that a larger entity can offer. Also noted as one of the more important benefits of an UPREIT transaction‚ is that such a transaction allows an interest in liquid real estate properties to become more easily saleable. This is because OP Units may be converted‚ subject to minor restrictions‚ on a one-for-one basis for shares of common stock of the private or publicly-traded REIT. While such a conversion to stock may trigger recognition of taxable gain‚ the flexibility permits the owner to unlock value and access capital as needed.
The capital gain taxes remain deferred as long as the operating partnership holds the property and the OP Unit Holder holds the OP Units. In other words‚ capital gains taxes become due if: (a) the OP Unit Holder exchanges the OP Units for REIT shares; (b) the OP Unit Holder exchanges the OP Units for cash; or (c) the subject property is sold by the operating partnership. In the last instance‚ however‚ the operating partnership can sell the property as part of a 1031 exchange and avoid the trigger of gain to the OP Unit Holders that contributed the property being sold. As mentioned above‚ if the OP Units are owned at the time of death of an OP Unit Holder‚ there would be a step-up in basis eliminating any taxable gain which existed prior to death. Thus‚ REIT’s with long-term holding periods‚ such as AMR R‚ Inc.‚ often provide OP Unit Holders with the best long-term tax deferral or a tax planning period. One nice tax planning feature about OP Units is that they can be converted over time so as to spread out and lessen the tax impact. Also mentioned above‚ OP Unit Holders have the right to convert their OP units into REIT shares on a one-for-one basis. Conversion from OP Units to REIT shares is considered a taxable event‚ so the investor may choose to convert over time‚ which enables the investor to incur any tax liability in smaller increments
Perhaps the most well-known way for an owner of real estate to defer the tax on capital gain is to exchange the real property for another real property in a “1031 exchange” (after Section 1031 of the Internal Revenue Code). In a 1031 exchange‚ the property being sold in the exchange is referred to as the “relinquished property” and the property being acquired in the exchange is referred to as the “replacement property.” According to IRS requirements‚ within 45 days after the sale of the relinquished property‚ the owner must identify the replacement property. Once identified‚ the owner must acquire the replacement property within 180 days after the sale of the relinquished property. Thus‚ the property owner faces challenging time frames to identify the replacement property and to negotiate and close the sale and the purchase. And because the owner has sold one property and acquired another‚ there will be no change in liquidity and likely no change in property management responsibilities.
A viable‚ tax-deferred alternative to a 1031 exchange is what is known as a “721 exchange” (after Section 721 of the Internal Revenue Code) or “UPREIT transaction.” As described in this memorandum‚ in an UPREIT transaction‚ a property owner contributes its property to the operating partnership of a REIT in exchange for OP Units. The same tax deferral is achieved as in a 1031 exchange‚ but with more benefits.
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