In the Umbrella Partnership Real Estate Investment Trust, the “721” refers to Section 721 governing these transactions. In a 721 upright structure, property owners contribute their real estate assets to an operating partnership (OP) in exchange for OP units, which later become REIT shares. This structure offers several potential benefits, including tax deferral, portfolio diversification, and access to institutional-grade real estate investments. Investors must avoid several common pitfalls to leverage these advantages fully.
Inadequate due diligence on the REIT partner
One of investors’ most critical mistakes when considering a 721 UPREIT transaction is failing to conduct thorough due diligence on the REIT partner. When you contribute your property to a UPREIT, you become a partner in that REIT’s portfolio. To avoid this mistake:
- Research the REIT’s track record, including its historical performance, dividend history, and growth strategy.
- Evaluate the quality and diversity of the REIT’s existing portfolio.
- Assess the experience and reputation of the REIT’s management team.
- Review the REIT’s financial statements and SEC filings to understand its financial health and potential risks.
Misunderstanding the tax implications
While 721 UPREITs offer significant tax deferral benefits, misunderstanding the tax implications leads to costly mistakes. Some investors assume that the tax deferral is permanent or that they fully understand all tax consequences without consulting a tax professional. To avoid this mistake:
- Consult with a tax advisor with specific experience with 721 upreit
- Understand that the tax deferral is temporary; taxes will eventually be due when you sell your OP units or convert them to REIT shares.
- Be aware of potential state tax implications, significantly if you’re contributing property in one state to a REIT based in another.
- Consider the long-term tax planning implications, including how the UPREIT structure might affect your estate planning.
Overlooking lock-up periods and liquidity constraints
Many investors are attracted to 721 UPREITs because of the potential for increased liquidity compared to direct real estate ownership. A common mistake is overlooking or underestimating OP units’ lock-up periods and liquidity constraints. To avoid this mistake:
- Carefully review the terms of the OP unit agreement, paying close attention to any lock-up periods during which you cannot convert your units to REIT shares.
- Understand any restrictions on selling your OP units or converted REIT shares.
- Consider your potential liquidity needs during the lock-up period and ensure you have other sources of liquidity if needed.
- Be aware that even after the lock-up period, there may be limitations on how many units you can convert or sell simultaneously.
Failing to negotiate favorable terms
Some investors need to avoid assuming that the terms of a 721 UPREIT transaction are non-negotiable. In reality, there’s often room for negotiation, and failing to do so could result in less favourable terms. To avoid this mistake:
- Consider working with a real estate attorney experienced in UPREIT transactions to help negotiate terms.
- Negotiate the valuation of your contributed property, ensuring it’s fairly valued relative to the OP units you’ll receive.
- Discuss potential tax protection agreements to safeguard against specific future actions by the REIT that could trigger tax liabilities for you.
- Explore possibilities for board representation or other input forms into the REIT’s decision-making process, significantly if you’re contributing a significant property.
With careful planning and expert guidance, 721 UPREITs is a valuable addition to your real estate investment strategy, offering the potential for portfolio growth and tax-efficient wealth preservation.
