Passive Income, Active Impact: How to Fund Your Future and Your Causes with an UPREIT
- Laura Malone
- 5 hours ago
- 4 min read
For those real estate investors who want to move their investment in physical real estate to the easier passive world of real estate investment trusts (REIT), there is an unfortunate tax hit awaiting them. Using a 1031 exchange is not an option available to you. The IRS views REITs as securities, not real estate, and therefore 1031 exchanges do not apply.
However, your dream of moving to an easier real estate investment ( and using these resources to help build a charitable legacy as well) are not lost. A unique legal entity known as an umbrella partnership real estate investment trust (UPREIT) allows you to make a “tax-deferred swap” with which to trade your physical property for a stake in a diversified portfolio, without triggering the massive 40% tax hit that would occur otherwise.
This article will not only help explain the process but illustrate how these new holdings can help you design a charitable legacy for your future giving.
Tax Trap: The Problem with a Direct Sale
A 1031 exchange relies on the concept of a “like-kind” exchange; physical real estate is being exchanged for physical real estate. A REIT is not that; it is a security, just like owning stock in a company like Meta or Apple.
If you are selling physical commercial real estate, you end up facing the “miserable math” of a potential 40% tax hit, that includes:
federal capital gains tax (15-20%)
net investment income tax (3.8%): This is a surtax on passive rental & business income.
state taxes
depreciation recapture (up to 25%): This is the IRS clawing back prior tax breaks. When you owned your commercial real estate, you were able deduct the wear & tear on the property each year through depreciation. Once you sell your property at a gain, the IRS is taxing the portion of your gain that represents the depreciation you previously claimed.
UPREIT – The Section 721 Exchange
IRC Section 721 allows you to trade your physical property for an ownership slice of a partnership. This is the engine behind an UPREIT. Think of the UPREIT as an "umbrella" that sits over an operating partnership (OP). While a standard REIT owns buildings directly, an UPREIT manages the OP, and the OP owns the buildings. When you contribute your property, you join the UPREIT as a limited partner within that underlying partnership.
The process of implementing a 721 exchange is as follows:
Contribution: You deed your property to the UPREIT's operating partnership.
Issuance of OP Units: Instead of cash, the UPREIT gives you OP Units. The value of these units is pegged 1:1 to the UPREIT's public share price.
Tax Deferral: Under IRS Section 721, this is viewed as a "contribution to a partnership." Since you haven't "sold" the property for cash, your capital gains and depreciation recapture taxes are deferred.
Dividends: You receive quarterly distributions (dividends) on your OP units, exactly as if you owned the public shares.
Two Paths to Completion
Depending upon the size of your real estate portfolio can determine which route to go:
Direct Path: If you own an asset valued at $20 million+( like a shopping center or office building) , you are a large enough investor to deal directly with an UPREIT.
Two-Step Path: If you own several former single family homes that are now rental units, you are not going to be able to deal with an UPREIT directly yet. Your holdings are not large enough. You would need to take the first step in using a 1031 exchange to convert your property value into an UPREIT-sponsored Delaware statutory trust(DST). After a two-year holding period, you can roll your DST interest into the sponsoring UPREIT. Your DST interest is converted into OP units.
Charitable Giving with an UPREIT
Your OP units represent a triple-tax win for your taxes and the causes that matter to you. If you donate your OP units to a charity or donor advised fund (DAF). You receive:
Win #1: Eliminate the Capital Gains Tax Because you are donating the asset directly, you never "trigger" the sale. You avoid the 15–20% federal capital gains tax and the 3.8% net investment income tax entirely.
Win #2: Bypass Depreciation Recapture This is the biggest secret of the UPREIT-to-charity move. When you sell commercial property, the IRS "recaptures" the depreciation you took over the years at a high 25% rate. By gifting the units, that recapture tax often disappears—a benefit you can't get with a standard sale.
Win #3: A Full Market Value Deduction You generally get to claim a charitable deduction for the fair market value (FMV) of the units on the date of the gift, not just what you originally paid for the property. This deduction can offset up to 30% of your adjusted gross income (AGI).
Charitable Remainder Trust Option
If you still need income but want to give to charity or a DAF later, you can contribute your OP units to a charitable remainder trust(CRT).
-The trust receives the OP units and pays you an annual income stream for life.
-Because the trust is tax-exempt, it can eventually convert the OP units to shares and sell them without paying any immediate capital gains tax.
-The remaining assets go to your charity of choice or DAF after your passing.
Next Steps
Attempting to convert physical real estate into passive real estate investing can be a complicated process. Mapping out the best tax strategies, coupled with plotting a charitable legacy, can be confusing. An UPREIT may not be the best choice for you, your holdings, and your aims.
At Generosity Nexus, we have the depth of experience in helping you navigate the variety of options available, analyzing how your holdings can serve you and your causes in a tax-smart way.
Don’t hesitate to schedule an appointment to learn more about how we can help you.
