Managing capital gains and the tax burden it can generate is a critical consideration in preparing to sell real estate. Whether in a conventional sale or part of a sale-leaseback transaction, sellers should expect to owe taxes on any realized gain over their basis in a sold property.
That gain can be substantial, particularly for a business owner selling a property their company has occupied for many years. In many cases, real estate that has been home to a long-standing business will have experienced steady increases in value, especially if the surrounding submarket has also flourished and become more desirable during the seller’s period of ownership.
The Internal Revenue Code (IRC) allows deferral of capital gains tax on real estate if the taxpayer follows specific rules. The most common route is to sell the first property and purchase another real estate asset of similar value in a like-kind exchange, as described in Section 1031 of the tax code. (Learn more about that strategy in our previous column, Tax Advantages Available to Sale-Leaseback Sellers.)
A second and lesser known tool to defer capital gains tax in a property transaction is to place the asset in an umbrella real estate investment trust, or UPREIT.
Open Umbrella
An UPREIT is a form of real estate investment trust that allows a property owner to trade their property for shares in the trust. The process is governed by IRC Title 26, Section 721, which describes property-for-share exchanges. Hence, the practice of trading real estate for UPREIT shares is sometimes referred to as a 721 exchange.
Instead of cash, the seller in a 721 exchange receives shares equivalent to the value of their contributed property. This offers several advantages, including ownership interest in a professionally managed portfolio of properties that is usually further diversified by tenant mix, geography, and property type.
Shareholders can expect a passive income stream from their shares in the form of regular dividends, typically paid quarterly. And because a property-for-share exchange doesn’t create a taxable event, there is no capital gains tax to be paid.
It is important to note that UPREIT participation is subject to normal REIT tax rules. Investors should consult with a tax professional before undertaking any real estate transaction or investment to explore the tax implications for their circumstances.
Many business owners performing a sale-leaseback of their company’s real estate prefer an UPREIT structure over a 1031 exchange. Although there are timing requirements associated with either process, the UPREIT approach avoids the need for a potentially exhaustive property search for the up-leg acquisition. Some people have found UPREIT investments helpful in estate planning, due to the simplicity of separating shares among multiple heirs.
If you are considering a sale-leaseback to extract the equity built up in your business’ real estate, a property-for-share exchange with an UPREIT may be the best way to maximize value and position yourself for the future. Ascension works with a number of REITs offering UPREIT investment options, and we would be happy to help find the one best suited to your needs.
We hope you will reach out to us. Together, let’s explore the ways real estate could be helping you achieve your goals.