An interesting development over the past few years is the use of the Section 721 exchange into an UPREIT as an alternative exit strategy for a DST property. Since 2010, some DST sponsors offering portfolios of NNN retail properties and multifamily properties have been providing the UPREIT as an option to their DST investors. A 721 exchange is considered an option for investors of DSTs after the standard 5- to 7-year hold period or, at a minimum, after the required 2-year hold period for a Section 1031 exchange.
The umbrella partnership real estate investment trust, or simply an UPREIT, is a unique structure created for real estate investors to exchange their property, such as a DST property interest, for ownership units in the umbrella partnership of a REIT. This exchange is tax-free and allowed under the Internal Revenue Code (IRC) Section 721 exchange. Some have called it one of real estate investing’s best-kept secrets. Like the chicken and the egg, it’s hard to know which to address first—the UPREIT or the 721 exchange. In this context, the UPREIT is analogous to the chicken and the 721 exchange to the egg, so let’s start with the chicken.
Real estate investment trusts (REITs) were first introduced by Dwight D. Eisenhower in the 1960s, and the tax benefits have evolved over time. Initially, the REIT was intended to be a type of alternative real estate mutual fund comprised of a portfolio of real estate properties. When an REIT is first formed, the trust can choose to take on any type of business structure. Publicly traded REITs are structured as corporations, while private REITs are generally structured as a trust or an association. Investors make cash contributions into the REIT for equity units or shares of the business.
If the REIT meets certain Treasury Department requirements, it is treated as a pass-through entity for tax purposes. To qualify, an REIT must invest at least 75 percent of its assets in real estate, obtain at least 75 percent of gross income from sources such as rent and mortgage interest, and distribute 90 percent of its taxable income to shareholders. If the REIT meets these requirements, it passes its income to its shareholders, and the pass-through income is considered a deduction for the REIT, which pays little to no taxes.
In a typical UPREIT structure, the REIT holds its assets and conducts its operations through a single operating partnership (OP) or umbrella partnership (the UP in UPREIT) subsidiary. Generally, the REIT serves as the sole general partner of the operating partnership. As a result, the REIT has exclusive authority to manage the partnership operations but is limited by the rights reserved for the holders of limited partnership interest units (OP units) pursuant to the partnership agreement.
In addition to controlling the operating partnership, the REIT owns most of the outstanding OP units. These OP units are obtained by the REIT in exchange for the contribution of the net cash proceeds from the REIT’s equity capital raise or IPO. The remaining OP units are held by outside limited partners (OP unitholders) who contribute real estate assets that were previously owned by the partners. These properties, or the interest in the entities owning these properties, are contributed to the operating partnership via a 721 exchange for the OP units equal in value to the REIT’s common stock.
An UPREIT, or a 721 exchange of interests in a single property for operating partnership units of an REIT, is an advantageous option for real estate investors for multiple reasons. First and foremost, transferring a property into the operating partnership of an UPREIT allows for a deferral of taxable gain (including depreciation recapture) from the transfer of the underlying real estate. However, if an investor transfers a property into an UPREIT, it no longer qualifies for a 1031 exchange. Once OP units are sold, there is a capital gains tax on the difference between the sale price and the allocated carryover basis in the units. If the OP units are held until the death of the investor, then there is a stepped-up basis to the heirs under current tax law.
Another advantage of an UPREIT investment is the opportunity for a more nuanced portfolio diversification. An UPREIT provides the possibility to diversify from a single property into a larger number of investment-grade properties, diverse geographical locations, and various asset classes. REITs, both publicly traded or private offerings, pool large amounts of investor capital to acquire a variety of asset classes such as multifamily, office buildings, industrial, retail stores, hospitality, and medical facilities.
Like a DST investment, an UPREIT provides the private investor with passive management of the properties. Instead of an active property management role, with its time-consuming challenges, UPREIT investments are overseen by a professional management service established by the principals of the operating partnership. These are seasoned real estate experts with extensive institutional real estate experience in the acquisition, development, management, and disposition of properties within the asset class(es) of the UPREIT portfolio.
A more indirect advantage of the UPREIT is the possibility to effectively de-lever or eliminate personal mortgage debt on a DST investment while still enjoying the tax shelter from additional basis provided by the debt. If the original DST investment has mortgage debt, the UPREIT will assume the mortgage debt encumbering the DST property being transferred to an UPREIT through the 721 exchange process. The DST investor will receive OP units for the full value of the appreciated equity interest in the DST and, at the same time, be released from the nonrecourse debt the investor assumed when the DST was acquired. Nonrecourse DST debt is often used in the 1031 exchange to replace the debt on the original relinquished property to avoid mortgage boot and enjoy a fully tax-deferred exchange.
When the DST, without an UPREIT option, is ultimately sold and another 1031 exchange is utilized, the DST debt must be rolled into a replacement DST with equal or greater debt. The continuous assumption of debt for a tax-deferred 1031 exchange must be perpetually carried forward. The debt carryforward can be reduced by amortization along the way, but the investor needs to continue to assume non-recourse debt until the investment is either cashed out and taxes paid, or the investment is passed to heirs tax-free with the stepped-up basis. Alternatively, the UPREIT of a DST is the end of the road for the assumption of debt by the individual investor, as the operating partnership or the REIT will assume the debt at the entity level. This provides for an effective de-leveraging of the investment that can pass to heirs or others debt-free.
When the debt is assumed by the UPREIT, the investor’s tax basis in the OP units is the adjusted tax basis carried over from the contributed DST and includes any additional tax basis from additional debt that was assumed (above the relinquished debt) when the DST was acquired. This adjusted tax basis will continue to provide tax shelter to the investor on income from the UPREIT for decades or as long as the UPREIT interest is held (the maximum limit being 27.5 years for residential and 39 years for DST commercial properties contributed to the UPREIT).
REIT rules require the distribution of 90 percent of the rental income to investors. The income level, or the share price distribution rate, is determined by the Board of Directors and is paid quarterly. Due to the high degree of portfolio diversification over tenants and geographic markets, income distributions from the UPREIT can be more stable and more consistent than from a single property or fund.
UPREITs provide for greater liquidity than traditional single-property ownership. REITs that are traded on a public exchange are considered fully liquid and can be sold at any time. At the time of sale, operating partnership units are exchanged for shares in the public REIT and, in most cases, settle the same day as they are offered for sale through the investor’s security brokerage account.
Private REITs that are registered with the SEC but not traded on a public exchange have a formal redemption plan. These plans provide for the redemption of up to 5 percent of outstanding shares in any given year. The REIT redeems the shares at a set price, depending on the length of time the shares are held. However, if there is a large amount of redemption requests, the annual maximum percentage of redemptions can limit liquidity.
The redemption program of an UPREIT provides an interesting tax planning opportunity. I stated earlier that when doing a 1031 exchange into a DST, the taxpayer’s basis in the relinquished property is carried over to the new DST investment, along with any additional basis. Both the old and new tax bases are then carried over as the adjusted basis for the UPREIT investment. At some point, if the UPREIT shares are redeemed, the investor’s tax basis is considered a return of capital and is tax-free. Any redemption proceeds above the investor’s tax basis in the UPREIT are considered long-term capital gains and are taxable. Assuming additional debt on a DST for a relatively short hold period may ultimately provide for tax-free redemption dollars. This return of capital strategy does not apply to an outright sale of the UPREIT shares to a third party or in the public markets if the REIT had a public offering.
The UPREIT is a helpful tool in estate planning. Individual properties inherited by multiple heirs present challenges due to the various investment objectives, risk tolerances, and liquidity needs of the heirs, who are at various stages in terms of age and socioeconomic standing. Deciding to sell or keep a mutually inherited property could cause unnecessary discord among family members and loved ones. If the property to be inherited is an UPREIT investment prior to the benefactor’s passing, ownership shares are assigned or allocated to heirs by means of a will or trust. This provides for a more manageable allocation of wealth to the heirs and allows each heir to make their own decision regarding the timing of the disposition of the inherited assets based on their unique financial objectives, liquidity needs, and tax exposure. These estate planning features make the UPREIT an ideal investment opportunity.
The UPREIT is not the best option for every investor, and the disadvantages might make the investment structure unsuitable for some investors. For example, investors in an UPREIT have limited voting rights and limited control. Operating partnership unit voting rights are limited by design and are only applicable to issues affecting investor rights, tax allocation, and redemptions. In addition, once assets are contributed through the 721 exchange process, the UPREIT is the owner of the property and exercises full control over the property.
Another disadvantage is future tax exposure due to the possible sale or refinance of the asset contributed by the REIT. If the REIT ultimately sells the property contributed by the UPREIT investor to a third party, it will subject the investor to capital gains tax and depreciation recapture unless the REIT employs a 1031 exchange to reinvest the proceeds. Another possible exposure to tax on gain could arise if the REIT refinances the property contributed to the UPREIT for a lower loan amount. The gain is calculated using the adjusted basis from the cash investment into the original property and carried over through previous 1031 exchanges and the 721 UPREIT exchange. While some REITs will indemnify the investor for a period of years, most tax indemnification provisions do not go beyond 7 years. This should be of particular concern with larger wire house UPREITs, as they may undergo multiple mergers and acquisitions worth billions of dollars to the managers with little concern for the individual investor’s tax exposure.
Unlike DST properties, UPREIT investments are more exposed to increased volatility. If the REIT is an equity REIT that is publicly traded on an exchange, share values are affected by overall market volatility, even if the individual property values remain stable. In addition, share values are affected by management decisions and the required third-party appraisals of the properties, financing terms, and other factors.
UPREIT investments have specific tax filing requirements that some investors might find disadvantageous. The REIT shareholders receive a Form 1099 and are required to file income taxes in their state of residency regardless of which states the REIT properties are situated. However, operating partnership unit holders receive a Form K-1 and are required to file an income tax return in each state in which the operating partnership owns properties. Depending on the amount of the investment, the reporting issue is mitigated by allocating income to multiple properties in multiple states, deducting applicable interest expenses, depreciation deductions, state-level standard deductions, and personal exemptions. Thus, the taxable income might be below the filing requirement of the state. The OP can elect a consolidated tax filing that relieves the individual owners from having to file returns in multiple states.
Syndicated UPREITs are private REITs that have a set equity raise. The equity for an UPREIT is limited by a private placement memorandum (PPM) and is raised from investors within a limited time frame. In most cases, the total amount of equity set for an UPREIT is between $100 million to as much as $1 billion. The main advantage of a private REIT investment is the significant level of diversification and access to high-value institutional-grade properties.
Private REITs distribute cash flow in addition to the stated preferred return. The cash flow is distributed either by its funds from operations (FFO) or by a return of invested equity that reduces the REIT’s net asset value (NAV). An FFO is a key factor in evaluating the financial stability of an REIT and provides more insight than the typical earnings per share. The FFO is calculated by adding depreciation, amortization, and losses from the sale of REIT assets to the stated earnings and subtracting out interest income, including any gains from the sale of REIT assets.
Many of the larger wire house UPREITs that have entered the industry in the past few years in an effort to get more money under management do not cover their distributions from FFO. Some are even so low that they do not cover debt service. When a REIT does not cover its distribution by generating sufficient funds from operations, it indicates that the REIT is using new investor money to pay distributions to other investors, a trend that is extremely corrosive to net asset value (NAV) and the value per share. Here are some of the worst offenders based on their reporting on June 30, 2025:
Fund Distribution Coverage from Adjusted-FFO
Ares Real Estate Income Trust 26.86 percent
Ares Industrial Real Estate Income Trust 43.16 percent
Blackstone Real Estate Income Trust 50.49 percent
Hines Global Income Trust 42.35 percent
JLL Income Property Trust 72.57 percent
NAV refers to the estimated market value of the REIT. This value, in turn, determines the share price of the trust. To calculate a REIT’s share value, divide the NAV by the total authorized and outstanding shares. In addition to FFO and NAV values, investors can determine the REIT’s true operating performance by calculating the earnings before interest, taxes, depreciation, and amortization (EBITDA). EBITDA is a standard disclosure on most financial statements. A common financial ratio that helps assess the potential debt risks for REITs is the ratio of EBITDA to the interest expense.
The main attraction for UPREIT investments is access to non-stock market correlated institutional quality assets with greater diversification on a tax-deferred basis. In most cases, the REIT specifies in its PPM (or prospectus) the type of real estate or asset class it will acquire and manage. Currently, the alternative real estate investment industry offers REITs that focus on multifamily apartment communities, student housing, industrial properties (including self-storage and Amazon distribution centers), net-leased retail stores with national tenants (such as Walgreens, CVS, Tractor Supply, Walmart, etc.), hospitality assets, as well as REITs that diversify into multiple asset classes.
A further consideration for exchanging a DST investment into an UPREIT is the potential of a future public offering that could help to mitigate tax liability if the investment is ever sold. Most alternative investment UPREITs are private but have the potential to approach the critical mass necessary to undertake an initial public offering (IPO). The UPREIT needs to be large enough, in both portfolio property and equity capital, to make an IPO feasible—typically $1 billion in total property value. Once an UPREIT is listed publicly, the share price has the potential to increase in value and outweigh the associated tax liability (if divested). However, the potential for the share prices to outweigh the tax liability is dependent on the acquisition cap rates, the advantage of lower DST interest rates on the debt assumed by the UPREIT, and the current cash flow distributions for the properties in the UPREIT portfolio, as the market price for the shares would be priced to the market’s price-to-earnings ratio. Of course, there is a risk that market factors could move in the opposite direction, and the public share price could fall below the UPREIT share value, resulting in unrealized losses.
While it is true that no two UPREITs are alike, the contrast could not be greater than the differences between the wire house UPREITs and the broker-dealer UPREITs. Sprinkled throughout the chapter are references to the wire house UPREITs, including possible tax exposure from sale or refinance and poor coverage of distributions from funds from operations (FFO); however, the greatest contrast lies in the fee structure.
After nearly a decade of successful broker-dealer UPREIT activity, one may question why the larger wire houses have entered the DST and UPREIT industry. These wire houses have traditionally been stock and bond portfolio managers, which manage their clients’ stock market investments for a fee that is based on the aggregate value of the investor’s assets under their management, also known as money under management (MUM). These firms and their advisors have minimal experience in real estate and the tax consequences of a Section 1031 exchange, with a limited selection of DST properties, too little leverage options to avoid taxable mortgage boot, superficial due diligence underwriting standards, and poor real estate quality, as evidenced by declining distributions, falling value per share, and an inability to cover distributions. Accordingly, they have entered the DST and UPREIT market not to provide outstanding real estate offerings to private investors but rather to entice them to bring not only their stock market assets but also their real estate assets under their management to further enlarge their total assets under management and increase their annual fees. These fees may range from between 1.25 percent to 2.5 percent per year and are based on the property’s total value, in contrast to the broker-dealer’s one-time commission based on just the investor’s equity in the property. In doing so, the wire house has created one of the “stickiest” assets under their management. Once an investor touches this “tar baby,” he will never leave for fear of the tax exposure to the built-up capital gain. They have a dedicated client for the investor’s entire natural life, charging an average of 1.5 percent each and every year. Over the course of 20 years, this could amount to a fee load of over 30 percent in addition to the 20 to 30 percent profit sharing on the back-end exit of the UPREIT, unlike a DST where 100 percent of the appreciation goes to the investor.
With a greater focus on fees rather than quality real estate underwriting, the investor pays a double cost when steered into a wire house UPREIT by a stock market advisor with little real estate experience and an overriding career goal of building up his money under management in lockstep with the orders of the wire house. As is often the case, we can discern the intent of the wire house in accessing the DST and UPREIT real estate industry simply by following the money.
The investor can decide to execute a 721 exchange into an UPREIT, gaining greater diversification and higher potential cash flow while continuing to defer capital gains from the appreciation of the DST investment. This UPREIT option is attractive to investors looking to hold the UPREIT investment for a long period and potentially pass it on to an estate, in which shares are divided between beneficiaries. An UPREIT provides potential liquidity through a shared redemption program or through an IPO listing. An UPREIT is a valuable tool in achieving the underlying goals of portfolio diversification into institutional-quality alternative real estate investments with tax-sheltered gains and less exposure to volatility.