Investing in an UPREIT, which involves exchanging interests in a single property for operating partnership units of a REIT, offers several advantages for real estate investors. Firstly, transferring a property into the operating partnership of an UPREIT allows for the deferral of taxable gain, including depreciation recapture, from the transfer of the underlying real estate. However, it’s important to note that once a property is transferred into an UPREIT, it no longer qualifies for a 1031 exchange. Additionally, when OP units are sold, there is a capital gain tax on the difference between the sale price and the allocated carryover bases in the units. However, if the OP units are held until the investor’s death, there is a stepped-up basis to the heirs under current tax law.
Another advantage of investing in an UPREIT is the opportunity for a more diversified portfolio. By participating in an UPREIT, investors can diversify from owning a single property to having interests in a larger number of investment-grade properties across diverse geographical locations and various asset classes. REITs, whether publicly traded or offered privately, pool significant amounts of investor capital to acquire a wide range of asset classes, including multifamily properties, office buildings, industrial spaces, retail stores, hospitality establishments, and medical facilities.
Similar to a DST investment, an UPREIT provides private investors with passive management of the properties. Instead of taking on an active property management role, which can be time-consuming and challenging, UPREIT investments are overseen by a professional management service established by the principals of the operating partnership. These experienced real estate experts have extensive institutional real estate experience in acquiring, developing, managing, and disposing of properties within the asset class(es) of the UPREIT portfolio.
Lastly, UPREIT properties generate consistent and reliable income for investors, making them an integral part of the cash flow base for the Cornerstone strategic plan for portfolio reallocation and living well. REIT rules mandate the distribution of 90 percent of rental income to investors. The income level, or the share price distribution rate, is determined by the Board of Directors and is paid out quarterly. Due to the high degree of portfolio diversification across tenants and geographic markets, income distributions from the UPREIT may be more stable and consistent compared to those from a single property or fund.
While UPREIT investments offer advantages, there are also some disadvantages that may make this investment structure unsuitable for certain investors. One major drawback is the limited voting rights and control that investors have in an UPREIT. The voting rights of operating partnership unit holders are limited to issues related to investor rights, tax allocation, and redemptions. Once assets are contributed through the 721-exchange process, the UPREIT becomes the sole owner of the property and exercises full control over it.
Compared to DST properties, UPREIT investments are more exposed to increased volatility. If the REIT is publicly traded on an exchange as an equity REIT, the value of shares can be affected by overall market volatility, even if the individual property values remain stable. Additionally, share values can be influenced by management decisions and the required third-party appraisals of the properties, financing terms, and other factors.
Another disadvantage of UPREIT investments is the specific tax filing requirements. REIT shareholders receive a Form 1099 and are required to file income taxes in their state of residency, regardless of where the REIT properties are located. On the other hand, operating partnership unit holders receive a Form K-1 and are required to file an income tax return in each state where the operating partnership owns properties. Depending on the investment amount, this reporting issue can be mitigated by allocating income to multiple properties in multiple states and taking advantage of deductions such as interest expenses, depreciation deductions, state-level standard deductions, and personal exemptions. This may result in taxable income below the filing requirement of the state. Alternatively, the operating partnership can elect a consolidated tax filing, relieving individual owners from the burden of filing returns in multiple states.