While President Joe Biden has stated up front that his tax proposals would increase a variety of taxes for high-net worth taxpayers, a recent report from the Treasury Department known as the Green Book provides details that show a significant impact on high-income real estate investors, primarily stemming from proposed limitations on 1031 like-kind exchanges coupled with increased tax rates on long-term capital gains.
The proposal associated with like-kind exchanges would allow the deferral of gain, up to an aggregate amount of $500,000 for each taxpayer ($1 million for married individuals filing a joint return) each year for like-kind exchanges of real property. Taxpayers would recognize gains from like-kind exchanges exceeding $500,000 during a tax year (or $1 million for married individuals filing a joint return) in the year they transfer the real property subject to the exchange. The proposal would be effective for exchanges completed in tax years beginning after December 31, 2021.
Like-kind exchanges have been part of the tax code since 1921 and have allowed for taxpayers to exchange property that is similar and defer the recognition of gain. Before passage of the Tax Cuts and Jobs Act(TCJA) in 2017 some exchanges of certain intangible property and personal property, such as franchise licenses, aircraft and equipment, qualified for like-kind exchange treatment. However, starting in 2018, like-kind exchanges became limited to only real property as defined in Section 1031 of the tax code and new regulations.
While real estate operators and investors may feel limited under the new proposals, as they face a substantial increase in capital gains tax and significant limitations on the traditional option to defer those gains, one attractive alternative includes a 721 Exchange (UPREIT) transaction. UPREIT stands for Umbrella Partnership REIT, which is an operating partnership subsidiary of a REIT that holds and operates real property.
Through an UPREIT structure, real estate owners, operators and investors can exchange their real property for operating partnership units (OP Units) in a REIT without paying any tax at the time of the transaction (i.e., 100% deferment). After a holding period, at the option of the unit holder, the OP Units can be converted to REIT common shares, which would then trigger a tax. The exchange (i.e. contribution) of the investors’ real property to the REIT in exchange for OP Units is considered a tax-free exchange under Section 721 of the Internal Revenue Code. Section 721 generally provides tax-free treatment to partnership contributions and is not limited to the UPREIT context. Accordingly, as long as the investor continues to hold the OP Units the tax on the potential gain from the original transaction continues to be deferred. Once the OP Units are converted into REIT shares, a taxable event occurs, the deferred gain is triggered and tax is due.
One additional tax issue that can’t be ignored involves the investor who contributes property with a built-in gain or loss to the operating partnership in a 721 Exchange. In most scenarios when an investor agrees to contribute real property to an operating partnership in exchange for OP Units, the tax basis of the contributed property is lower or greater than the fair market value of the property at the time of the contribution, creating a built-in gain or loss. If an investor contributes property to a partnership with a built-in gain or loss, the built-in gain or loss must be allocated to the contributing partner when it is recognized by the partnership. In most cases this is when the partnership disposes of the contributed property in a taxable transaction. Similarly, future depreciation and amortization deductions arising from contributed property with a built-in gain or loss must be allocated among the partners, taking the built-in gain or loss into consideration by allocating depreciation and amortization away from the contributing partner, which indirectly has the contributing partner picking up some of that built-in gain or loss ratably over time. These principles fall under Section 704(c) of the Code.
Although the 721 Exchange provides an investor similar tax deferment to a like-kind exchange transaction, there are other benefits a taxpayer may want to consider. One benefit is diversification. Generally, a REIT will have properties located in a variety of geographic locations, as well as having tenant, industry and, sometimes, asset class diversification. The individual investor participates in a diversified portfolio of real estate and is no longer concentrated and dependent on one asset to provide cash flow and appreciation.
A 721 Exchange can also provide an investor with a consistent income flow. The REIT and the operating partnership will provide the similar benefits of appreciation of the real estate, depreciation tax shelter, and income in the form of regular distributions so the investor has a level of cash flow similar to that of the previously-owned contributed property.
Lastly, there are significant estate planning benefits to the 721 Exchange. Investors can use the 721 Exchange to pass assets to their heirs. Upon death, the beneficiaries receive a step-up in basis and can avoid capital gains taxes and depreciation recapture. And although a step up at death would equally occur in the context of a like-kind exchange, the step up in the context of a 721 Exchange would occur in the basis of the OP Units. Upon conversion, the heirs could more readily dispose of the common shares in the REIT for cash as compared to looking to dispose of the real property, which may take a lot more time and come with added complications.
Disclaimer: While President Biden has proposed various tax increases, the final bill, if it were to pass, may be quite different than what is included in the President’s plan. The purpose of this article is to bring awareness to readers of potential tax policy changes that can significantly impact financial investing, with specific attention devoted to the real estate industry.
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