UPREITS and Biden Tax Proposals
By Daniel Smith, Director, Tax & Business Services
The Biden Administration’s American Families Plan proposes to raise taxes on real estate investments both during the period of time that investors generally hold and/or operate their properties – from a top marginal tax of 37% to 39.6% – as well as upon the liquidation of such investments.
Real estate investors may spend many years building their portfolio of investments. Some investors may start with small fixer upper properties. Eventually, through a series of purchases, sales, and reinvestments, a real estate investor may own multiple investment properties.
Real estate investors have to consider taxes with every sale of an investment property. There are two main ways that investors might owe taxes when they sell their investment in real estate:
- Appreciation or increase in value – The property is sold for more than is the amount invested.
- Recapture of depreciation expenses.
Section 1031 exchanges have been one way real estate investors are able to grow their real estate portfolios. Using a Section 1031 exchange, investors can defer taxes each time they sell an investment property and reinvest the proceeds in another “like-kind” investment property within 180 days. Currently, there is no limit to how many times an investor can execute back-to-back Section 1031 exchanges.
Real estate investment strategies often have no fixed end. Frequently, the strategy is to make successive Section 1031 exchanges until the investor’s death. Then, the investor’s heirs receive a stepped-up basis on the properties, eliminating the need to pay income taxes on the gain. With high estate tax exemptions (currently $11.7 million for an individual and $23.4 million for a married couple), frequently, there also are no estate taxes.
The Biden Administration’s tax plan proposes to eliminate Section 1031 exchanges for taxpayers with more than $400,000 in annual income. If investors can no longer defer gains upon the disposal of their investments, those with income above $1 million will be faced with the proposed increase in capital gains rate, from 20% to the top marginal rate of 39.6%. . These investors will also need to plan for the proposed elimination of the stepped-up basis of the investment property upon the death of the owner and other significant changes in estate tax considerations (this is beyond the scope of this article).
A current exit strategy which has not been mentioned in the Biden tax proposals is the use of an Umbrella Partnership Real Estate Investment Trust, or UPREIT. An UPREIT is a strategic partnership structure that allows a real estate investor to defer capital gains, but often with improved diversification, liquidity, and more strategic tax management.
Through an UPREIT, a real estate owner contributes ownership of the property to an operating partnership owned by a Real Estate Investment Trust (REIT). The REIT is typically a publicly traded entity that raises cash by selling stock. The REIT then contributes the cash to the operating partnership in exchange for operating partnership units. The REIT usually acts as the general partner of the operating partnership.
A REIT is a corporation with special tax treatment, which combines the capital of many investors to acquire and/or provide financing for all forms of real estate. A REIT is in many ways like a mutual fund for real estate, with investors obtaining the benefit of a diversified portfolio under professional management. REITs do not pay tax at the corporate level, meaning there is no double taxation of the income to shareholders. In exchange for this special tax treatment, the REIT must comply with several requirements, one of which is that the REIT must distribute at least 90 percent of its annual taxable income to shareholders.
The original real estate owner receives limited partnership units of the operating partnership (OP units) in return for contributing the property. The contribution of property by a partner to a partnership is not generally a taxable event but is subject to certain rules at the time of contribution. Commonly, the UPREIT structure will include additional limited partners from other real estate investments, who have also contributed their properties into the operating partnership. This may provide additional diversification, as the partnership becomes a fund of various real estate properties, potentially mitigating risk.
The UPREIT structure provides an attractive tax-deferred exit strategy for owners of real estate who would otherwise recognize a significant taxable gain in a cash sale of a highly appreciated property with a low tax basis. If the real estate are transferred directly for shares of a REIT, the owner will have to immediately recognize the built-in gain in the year of the transfer. However, the real estate owner can avoid current gain recognition by contributing the property to the UPREIT in exchange for operating partnership units. The real estate owner will have a basis in the operating partnership units equal to the basis of the real estate contributed.
A contribution of property to a partnership is generally tax-free, and a distribution of cash from a partnership to a partner is generally tax-free to the extent of the partner’s basis in its partnership interest. However, certain tax regulations provide that a partner’s contribution of property to a partnership and a related distribution of money or other consideration from the partnership to the partner will generally be treated as a sale (“disguised sale”) if, when viewed together, they are properly characterized as a sale or exchange.
The capital gains taxes which would have been due upon the sale of the appreciated property remain deferred as long as the operating partnership holds the property and the original owner holds the OP units. Capital gains taxes become due if: (a) the OP unit holder exchanges the OP units for REIT shares; (2) the OP unit holder exchanges the OP units for cash; or (3) the contributed property is sold by the operating partnership.
OP units may be converted over time so as to spread out and lessen any tax impact. 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 convert over time, which will enable the investor to incur any tax liability in smaller increments. Often, the REIT shares are sold soon after conversion to pay for any tax liability due.
The OP units are equal in value to the REIT shares and fluctuate in value in the same way. OP unit holders also receive distributions equal to the dividends paid on REIT shares. However, OP units and REIT shares are taxed differently. An OP unit owner is deemed to earn a portion of the total income of the operating partnership, including income from each of the states in which it transacts business. REIT shares generate income on dividend distributions to shareholders, which is taxable. Shareholders would generally only have to file a tax return and pay tax in their state of residency.
With the new Biden proposals regarding the taxation of real estate investments, time is of the essence to plan new exit strategies from such investments.
Should you have any questions about REITS, the Biden proposals, or any other tax matters, please reach out to your Marcum tax advisors.