Understanding Operating Partnership Units in UPREITs

By Thomas P. Roussel | March 11, 2024

Operating Partnership Units

Depending on your personal and financial goals, several factors might make you consider exiting your real estate investments. Perhaps the property management responsibilities are too time-consuming, and you decide you want to be a more passive investor. 

If you’re considering selling your investment or rental property for cash, you’ll likely trigger a significant taxable event. Using a 721 UPREIT exchange, you can avoid this taxation and reap the benefits of investing in real estate without having to buy and manage a property directly. 

What Is an UPREIT? 

An umbrella partnership real estate investment trust (UPREIT) is a unique partnership between property owners and REITs. It is a property acquisition transaction that enables an owner to contribute their property and real estate assets to a REIT in exchange for share ownership in that REIT.

Taxpayers can use this strategy to defer capital gains tax on the sale of their property. An UPREIT is also known as a 721 exchange, named after Section 721 of the Internal Revenue Code. UPREITs have similar benefits to 1031 exchanges, which allow investors to defer capital gains taxes from one property sale by reinvesting their sale proceeds into a replacement property.

With a 721 exchange, investors selling an investment property exchange it for units in the operating partnership. Later, they can convert these units to shares in a REIT. Investors can also structure a property sale as a 1031 exchange, but instead of searching for a like-kind replacement property, they obtain OP units in the UPREIT which represents their ownership interest in the UPREIT portfolio. After acquiring the property and holding it for 12-24 months, the owner contributes their fractional interest to the operating partnership.

Because property owners enter into an operating partnership with a REIT through this exchange, they receive tax-deferred operating partnership units (OPUs) when they dispose of their real estate.

What Are Operating Partnership Units? 

If an investor sells their property for cash, they trigger capital gain tax liability. Using an UPREIT structure, they can become OP unit holders, which enables them to defer gains on appreciated property until they sell their units. 

In a typical UPREIT transaction, an investor contributes their real estate directly to an operating partnership within a REIT in exchange for operating partnership units, or OP units. These OP units are equal in value to REIT shares and move up and down in value the same way. This means dividend distributions are also equal to the REITs. 

The main difference between REIT shares and OP units is how they’re treated at tax time. Investors with OP units in REITs earn a fraction of the partnership’s total income. Depending on where the REIT conducts business, this means the investor may have to report taxable income in several states. 

Alternatively, REIT shareholders are only taxed on their income in their home state. Unlike REIT shareholders, OP unit holders do not have voting rights. It’s important to note that property owners do not own an interest in the REIT itself, only the operating partnership. 

UPREIT and OPU Transactions in Real Estate 

Investors can convert their OP units into REIT shares. However, this is a taxable event. The gains an investor defers by receiving OP units will be due once they make the conversion. Performing this conversion over time with smaller portions of OP units instead of all at once may help spread out the tax consequences.

Investors can convert their OP units into REIT shares. However, this is a taxable event.

Investors must thoroughly check the agreement in the 721 UPREIT exchange before converting OP units into shares. Though this is a relatively straightforward process, the investor may be required to hold their units before making the conversion. 

Once the units are converted into REIT shares, the investor may sell them if they wish. Depending on the redemption plan of the REIT, the converted REIT shares may be sold immediately, which may also result in taxable gain.

Advantages of an UPREIT Transaction 

As a real estate investor, you might consider contributing property to an UPREIT for several reasons. These advantages will vary depending on the specific structure and agreements of the 721 exchange.

Tax Benefits

As with a 1031 exchange, a 721 UPREIT exchange offers significant tax advantages to investors. If you were to sell your property for cash, you would need to pay taxes on capital gains and depreciation recapture. These taxes reduce your profits from the sale and, therefore, your buying power for your next investment. 

Using a 721 exchange, you can avoid this taxable event. You would only realize the gains from the sale of your contributed property once you sold your units in the operating partnership or converted them into REIT shares. 

Passive Income 

An UPREIT allows you to benefit from income-producing real estate without actively managing your properties. For example, even if you hired a property manager to oversee administrative tasks, you would still be responsible for making decisions about your investment. 

With a 721 exchange, you become an UPREIT unitholder instead of a direct property owner. Instead, the UPREIT manager takes control of the asset portfolio. This enables you to potentially earn passive income from properties without the property management responsibilities. The income, made through distributions, generally equals the dividend paid on each share of the REIT.

Portfolio Diversification

An effective way to manage risk as a real estate investor is through diversification. Investing in multiple asset classes can make mitigating risk against market fluctuations easier and enable you to gain income from several sources. 

Through a 721 UPREIT exchange, you can diversify your investments through your OP units in the REIT. For example, the REIT may hold many assets across many industries and sectors, which may help you diversify your investments more than owning real estate properties outright. 

Increased Liquidity

Though real estate is not liquid, investors who convert their OP units into REIT shares may have more liquidity than owning direct real estate. This is because these shares can be sold more quickly and easily than selling a property. 

For example, investors can sell publicly traded REITs on public exchanges, enabling them to reallocate their capital to meet their investment needs.

Estate Planning Flexibility 

A 721 UPREIT exchange can also make it easier for investors to prepare their assets for beneficiaries. Real estate properties can be challenging to sell and split among heirs. With OP units from an UPREIT transaction, investors can divide the units among their heirs, allowing each heir to decide whether they want to hold or sell them. 

Beneficiaries who inherit OP units also receive a step-up in tax basis. This means the base value of the units will equal the value on the date of the owner’s passing, eliminating capital gains and associated taxes.

Achieve Your Real Estate Investment Goals With 1031 Crowdfunding 

Your financial and investment goals are unique. If you’re ready to sell your real estate property but want to reinvest, an UPREIT might be ideal for you. At 1031 Crowdfunding, it’s our goal to make investing easier for our clients through our state-of-the-art investment platform of tax-deferred opportunities.

Performing a 721 exchange can be challenging as you must identify a REIT that will be interested in your property. 1031 Crowdfunding offers Delaware Statutory Trusts (DSTs) with a 721 exchange option. We can assist you in completing a 1031 exchange into a DST and then a 721 exchange into an UPREIT in the future. Register for an investor account today to learn more about investing in REITs.

Register for an investor account.

This material does not constitute an offer to sell or a solicitation of an offer to buy any security. An offer can only be made by a prospectus that contains more complete information on risks, management fees and other expenses. This literature must be accompanied by, and read in conjunction with, a prospectus or private placement memorandum to fully understand the implications and risks of the offering of securities to which it relates. As with all investing, investing in private placements is speculative in nature and involves a degree of risk, including loss of your principal. Past performance is not necessarily indicative of future results and forward-looking statements and projections are not guaranteed to achieve the results described and your actual returns may vary significantly. Investments in private placements are illiquid in nature and there may be no secondary market or ability to sell the investment should the need for liquidity arise. This material should not be construed as tax advice and you should consult with your tax advisor as individual tax situations will vary. Securities offered through Capulent, LLC Member FINRA, SIPC.

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