What Is an UPREIT?

By Markets Fool.com

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An umbrella partnership real estate investment trust, or UPREIT, is an entity that REITs use to let property owners contribute their real estate property in exchange for operating partnership units that can be converted into REIT shares. Like a 1031 exchange, this transaction lets property owners avoid capital gains taxes on appreciated real estate.

The operating partnership, or OP, units received in an UPREIT transaction are generally similar to shares in the REIT, but they possess a few key differences. They'reequal in value to REIT shares, and their value can move up and down in the same manner. Additionally, the dividend distributions are equal to those paid to the REIT's shareholders. The major difference is their tax treatment. OP unit holders are deemed to earn a portion of the partnership's total income in each state where the REIT conducts business, which means they may have to report taxable income in multiple states. By contrast, REIT shareholders' income is taxable only in their home state, so only one state tax return is necessary. In addition, OP unit holders do not have voting rights, while REIT shareholders do.

OP units can be converted to REIT shares or cash, subject to certain restrictions, such as a minimum holding period.

Benefits of an UPREIT

There are several reasons why property owners may want to conduct an UPREIT transaction. Again, an UPREIT transaction allows the owner of an appreciated property to avoid capital gains tax, much like a 1031 exchange. This is because the investor is receiving an interest in the REIT's operating partnership, as opposed to shares in the REIT itself.

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Capital gains taxes on the property are deferred for as long as the OP units are held. Once the units are converted to REIT shares or cash, capital gains taxes will be due. In the event of an investor's death, units can be inherited with a stepped-up basis, thereby eliminating any taxable gain. This feature makes UPREIT transactions appealing for estate planning.

In addition to the tax benefits, an UPREIT transaction has these potential benefits, to name a few:

  • Diversification: While a 1031 exchange requires you to purchase a new property, an UPREIT transaction gives you an interest in an entire portfolio of properties. In other words, the value and expenses of your investment will no longer depend on just one property.
  • Liquidity: Real estate isn't a liquid asset. However, you can convert partnership units to REIT shares, which you can then sell or convert into cash. (Remember that doing so can create a taxable gain.)This flexibility can be a huge benefit.
  • Steady income: Income from one rental property can vary significantly with vacancies and maintenance expenses. REITs can provide more predictable income distributions.
  • Hands-off investing: After disposing of an investment property through an UPREIT transaction, you won't have to worry about property management anymore.

An UPREIT transaction can be a great option if you own investment properties that would produce substantial capital gains if sold, and if you want to take advantage of the benefits listed here.

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