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How a real property contribution can benefit you

Jan 17, 2023

When we think of exchanges in real estate, most often a 1031 exchange will come to mind.

A 1031 exchange requires an owner to sell their property and purchase a replacement property to defer tax.

In a 721 transfer, you can actually maintain ownership in the real property but contribute it to a partnership unit in exchange for partnership interest.

This allows for an owner to have continued ownership, defer taxes and likely have less management over the property. We often see these in an umbrella partnership real estate investment trust (UPREIT) structure.

If you’re interested in a 721 transfer, here are some potential benefits — and issues — to expect:

UPREIT structure exchange benefits

When you contribute property to an UPREIT, you are essentially transferring ownership of the property to the UPREIT.

In exchange, you will typically receive operating partnership (OP) units or membership interests, which represent an ownership in the partnership that operates the REIT. In this transfer, you do not currently own the shares of the REIT itself.

When the UPREIT owns and manages the property, it can generate income from rent or from the sale of the property. The UPREIT can often distribute a significant portion of the income generated to the owners as well.

Another benefit of contributing property to an UPREIT is that it allows property owners to defer paying capital gains taxes on the appreciated value of the property until the OP Units are sold or until the death of the property owner.

Additionally, an UPREIT structure allows the property owner to retain some level of control over the property. And the value of the OP units received may be affected by the performance of the REIT and the overall real estate market.

The UPREIT structure can also allow for shared risk for the property. Generally, when a property is contributed, the liability will shift to the members of the partnership as a whole.

Lastly, when a property is contributed to a partnership, it will generally have the ability for more capital from the other partners and even be able to share in their management skills and knowledge.

Potential 721 transfer issues

As much as these exchanges can benefit you, they are not without potential pitfalls.

The main downside with a 721 is the lack of cash. Since you’re not selling the property, you’re not gaining any cash through the exchange.

For example, if the real property exchanged is encumbered by debt, any net debt relief you receive in the exchange that exceeds your tax basis can result in taxable gain. So, if you do trigger some taxable gain through debt relief, there is no cash available to pay the tax.

Tax is also triggered upon conversion of OP units to REIT shares in an UPREIT structure, and if no cash is received upon the conversion, some of the REIT shares may need to be sold immediately to cover the tax.

Additionally, since this exchange involves other parties, it can be tricky to complete. The exchange is predicated on finding a partner or REIT interested in your property. If you can’t do that, you’ll need to consider other options like a 1031 exchange or an outright sale.

A 721 transfer also requires a level of commitment that other exchanges don’t. After completing one, you won’t be able to make the same tax-deferred exchange back into real property. So be certain before you exchange that you’re ready to move into a more passive investment.

How Wipfli can help

At Wipfli, our knowledgeable tax team is here to guide you through your 721. We help you understand the potential tax implications involved so that you can move forward in tax planning with confidence.

Contact us today to see how you can transform your investments.

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Author(s)

Dannielle Lewis, CPA
Partner
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Brianna N. Komppa, CPA
Senior Manager, Tax
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