Have the strict time frames around 1031 exchanges discouraged you from selling your investment property? Consider this investment strategy that creates diversification and passive income while still deferring your capital gains taxes. An UPREIT (Umbrella Partnership Real Estate Investment Trust) is an alternative to a 1031 exchange. The seller exchanges the property for securities called Operating Partnership Units, or OP Units, that are worth the same amount as the investor’s net equity in the contributed property.

The structure of an UPREIT is actually pretty simple. The portfolio of properties are owned through the umbrella partnership. Real estate owners contribute properties to the umbrella partnership in exchange for OP Units, which can ultimately be converted into REIT shares or cash. Dividends are paid on the OP Units and REIT shares, creating passive income for the shareholder.

Some confusion on UPREITs center around taxation. The UPREIT transaction where you sell your property in exchange for OP Units is eligible for tax deferral, making it an attractive exit strategy for owners of real estate who would recognize a considerable taxable gain. There would not be a tax liability if your particular property is later sold out of the UPREIT portfolio as long as the operating partnership reinvests the proceeds as part of a 1031 Exchange.

Should you decide to liquidate your OP Units in the UPREIT there will be a taxable event. You cannot exchange out of an UPREIT and maintain a tax-deferred status. The OP Units can be converted into traditional REIT shares, which can be sold or converted to cash. This transaction would cause a taxable event, but it demonstrates how OP Units are much more liquid than traditional real estate ownership. The shares can be converted over time to lessen the tax impact. UPREITs pay dividends on the OP Units and your dividend earnings are considered personal income, which is taxed based on your state of residence.

Many investors who want to move away from owning multi-tenant assets consider exchanging into single tenant net lease properties. This strategy can relieve some headaches that come with owning a shopping center, but you also lose many of the benefits. Any STNL property could result in much less tenant turnover, but having fewer tenants can turn out to be a riskier investment. It may also prove difficult to find a worthy replacement property in the short amount of time required for a 1031 exchange. In an UPREIT, you will benefit from instant diversification of numerous properties along with a simultaneous exchange.

UPREITs can be a great tool for estate planning. You can transfer your OP Units to your heirs tax-free. When the owner passes, the beneficiary receives a stepped-up basis on the OP Units to current market value for taxation purposes, therefore wiping away the gain between the present value and the adjusted basis. The heirs are allowed to convert the OP Units to REIT shares or cash without triggering capital gains tax. In addition, since OP Units are generally more liquid than real estate, you can use the liquidated shares to pay estate taxes.

UPREITs are gaining in popularity, and for good reason. If you have considered exchanging into single tenant properties, but you are wary of losing the diversification in your multi-tenant property, an UPREIT could provide you with instant diversification and many of the same tax benefits of owning real estate, such as depreciation and mortgage interest. An UPREIT can provide you with a low-maintenance real estate investment vehicle that yields these tax benefits and an attractive yield.

**The information in this article does not constitute tax or legal advice, please consult your CPA or attorney regarding your specific circumstances***