The taxes on the sale of your assets can be enough to make an investor second guess making the sale altogether—even if you need to liquidate to pursue other investments or escape from under the weight of an overwhelming portfolio.
Thankfully, the U.S. government and the IRS understand this and have thrown investors a bone. President Eisenhower first introduced the concept of a Real Estate Investment Trust or “REIT” as an alternative to traditional mutual funds. From there, the Umbrella Partnership Real Estate Investment Trust or “UPREIT” was born.
Understanding how an UPREIT works—as well as what’s involved in using one—can help you decide if you want to take advantage of this useful tool to defer taxes on real estate. To grasp what an UPREIT is and how it helps investors, you first have to understand what a REIT is.
What Is a REIT?
To understand an UPREIT, the best way to think about a REIT is as a publicly-traded portfolio of collective real estate holdings. They’re like an exchange-traded fund (EFT), but instead of consisting of a group of companies, they contain a conglomerate of real estate offerings. Like EFTs, they are publicly traded—and partial owners get shares of the portfolio.
What Is the “Umbrella” Purpose of an UPREIT?
Paying taxes is like rain; more specifically, paying taxes after you sell a piece of real estate is like rain. It never seems to stop—and there’s a lot of it. When you step under the “umbrella” of an umbrella partnership real estate investment trust, you are shielded from the rain of immediate taxation. Instead of liquidating a property into immediate cash, you transform it to shares in the UPREIT. This transition doesn’t trigger a taxable event.
Only after you’ve converted your unit shares will there be the potential to tax your earnings as income. However, this allows investors to liquidate smaller unit values at a time—rather than the entirety of a property. Until you decide to sell, you are protected from the gale force of taxation. Here’s how to get under the umbrella!
The Umbrella Protection of an UPREIT
To evade the storm of excessive capital gains taxation, all you have to do is take two steps:
- You use Section 1031 of the IRS code to acquire a fractional interest in real estate designated by the UPREIT. In other words, instead of collecting cash on the sale, you use it to receive unit shares. These shares are generally equivalent in value to the property you’ve surrendered. This is not to be confused with a 1031 exchange where the property you’re trying to offload is swapped for another.
- After holding your unit shares for a period, you can then exchange them for shares in the REIT using a 721 exchange. In other words, you step under the umbrella and become a partner.
Advantages of the UPREIT Structure
Imagine you have real estate worth $1,000,000. You could sell it—and get slapped with a few hundred thousand dollars in taxes—or you could use it to join an UPREIT. Let’s say you decide to take advantage of the UPREIT structure: after the 1031 and 721 exchanges, the value of your real estate has effectively been converted into shares of the REIT. These shares are liquid; you can sell them as you wish. Until you sell, you effectively defer taxes on real estate assets.
The ability to parse shares and use the profits to reinvest, pay off a debt, or make another kind of purchase puts the power back in your hands. Shares in the REIT are also far easier to bestow on a designated heir, friend, spouse, or next of kin. Before the UPREIT, you had a relatively illiquid asset: now, you have financial muscle worth flexing.
If you feel the value of the property you own is relatively unstable, relinquishing it in favor of a stable and balanced portfolio of geographically diverse properties is a smart move. While all investments undergo flux, REIT shares are stabilized by the balancing effect of diversification.
One of the reasons many investors get into real estate in the first place is the foundational support it provides riskier investments through such diversity. However, managing the extent of your portfolio can be draining over time. With the UPREIT structure, contributed properties are managed independently. It’s like getting to enjoy the profit from your real estate assets without the hassle.
Use an UPREIT for Profit
In addition to the relatively liquid state of your REIT shares, there are other financial advantages afforded through the UPREIT structure. One of the most powerful is a slice of the activities of the REIT. If the REIT decides to use the properties in its portfolio to engage in development, as a partner, you stand to benefit from that.
- Your partnership gives you access to sources of income that would have otherwise been out of your reach; an UPREIT is your ticket to the ball.
- Your assets are managed with the same tools and resources big time real estate players use to create wealth.
- This means that instead of merely sitting on the sidelines and watching the horizon change, your investment portfolio could grow in value along with the buildings the REIT constructs, leases, or sells.
Is There Even a Downside?
When you join an UPREIT, you no longer own the real estate you’ve surrendered; you own an interest in the REIT that manages your property pool. However, if your portfolio has gotten to be too much to handle alone, this isn’t a drawback! If anything, it’s the answer you’ve been looking for.
There is a measure of risk in choosing an UPREIT that is also asset-specific: this type of REIT is more sensitive to market conditions that directly affect the asset class they’ve chosen to focus on. You can circumnavigate this by selecting an UPREIT with diversified assets as opposed to a single focus.
Choosing the Right UPREIT
If your UPREIT of choice engages in business that significantly improves the value of your interest, there could be considerable financial benefits. Choosing the right UPREIT structure means more than the ability to defer taxes on real estate: you have the potential to earn more than you ever could have without it.
Still, finding the right UPREIT and navigating the entry process sounds confusing—especially if you’re familiar with the deadlines applied to a 1031 exchange! Thankfully, we’ve been where you’re standing: let The Peak Group be your guide! We know how important your portfolio is to your financial freedom—but somewhere along the way, it started becoming more of a prison.
It’s time to take back your investing power—and your long-term wealth! As former fix-flip and turnkey investors, we can guide you through the process. Get in touch with The Peak Group today and let us know more about your financial goals!