How Can I Avoid or Eliminate Depreciation Recapture with an UPREIT?

1. Introduction to Depreciation Recapture

Depreciation recapture can create a tax burden when a real estate property is sold. Over the years, investors benefit from depreciating the property, which lowers taxable income. However, this advantage can turn into a liability upon sale. The IRS taxes the previously deducted depreciation at higher rates, a concept known as “recapture,” which can significantly reduce after-tax profits.

For my clients, I suggest thinking of depreciation as a long-term, interest-free loan from the government. The repayment options depend on the planning strategy used: it can be paid back fully, at a reduced rate (approximately 65 cents on the dollar), or potentially forgiven entirely. This flexibility makes UPREITs an appealing strategy, especially for highly depreciated or highly leveraged properties.

2. Depreciation Recapture in Traditional Sales

Under standard sale conditions, depreciation recapture becomes taxable as the Tax Code “recaptures” past depreciation deductions. Typically taxed at a rate of up to 25%, depreciation recapture can create a substantial tax bill, cutting deeply into an investor’s net proceeds. This is in addition to capital gains on the appreciation of the property.

For example, if a property owner has claimed $500,000 in depreciation deductions, selling the property triggers recapture tax on those amounts, regardless of how much the owner benefited directly from those deductions over the years. This is particularly concerning for properties that have depreciated significantly or have been refinanced.  I have seen sales that net $0 dollars to the owner due to recapture, capital gains, and repayment of the mortgage debt.

3. How an UPREIT Works

A typical real estate investment trust (REIT) allows investors to hold a diversified portfolio of real estate. An Umbrella Partnership Real Estate Investment Trust, or UPREIT, allows property owners to exchange their real estate holdings for units in the REIT’s operating partnership (OP).

The process is straightforward: instead of selling a property directly, the owner contributes it to the UPREIT in exchange for OP units. This structure can provide flexibility and liquidity, much like a 1031 exchange but without the same restrictions. It’s an option for investors who want to defer taxes but may not want to manage a like-kind property or adhere to the strict timeframes of a 1031 exchange.

4. Deferring Depreciation Recapture with UPREIT Contributions

Contributing property to an UPREIT offers a significant tax advantage: deferral of both capital gains and depreciation recapture tax. Under IRC Section 721, when property is exchanged for partnership units rather than cash, the transaction is non-taxable, allowing investors to defer the gains.

This setup means that rather than immediately facing depreciation recapture, the investor gains OP units in the UPREIT, effectively “rolling over” the property’s basis. As long as they hold these units, the taxes remain deferred, allowing them to enjoy the benefits of liquidity and potential income from REIT distributions without triggering an immediate tax event.

5. Benefits of UPREIT Over a Traditional 1031 Exchange

While 1031 exchanges offer a way to defer taxes by exchanging like-kind properties, they come with significant restrictions, including the need for a replacement property and strict timelines. UPREITs, by comparison, allow property contributions without requiring a like-kind asset, making it easier for investors to access liquidity.

In addition, UPREIT units offer the flexibility of partial liquidation, where investors can gradually convert units into cash over time if needed. This option is unavailable in a traditional 1031 exchange, where the investor is required to invest in a single, new property to defer taxes. For those seeking diversification, liquidity, and ongoing deferral, an UPREIT can be a highly effective alternative to a 1031 exchange.

6. Potential for Eliminating Depreciation Recapture on Inherited UPREIT Units

One of the most powerful benefits of using an UPREIT to defer depreciation recapture is the potential to eliminate it entirely through estate planning. When an investor passes away, their heirs may inherit UPREIT units rather than direct real estate holdings. Through the step-up in basis at death, both capital gains and depreciation recapture liabilities can be forgiven, removing the tax liability on gains.

However, it’s worth noting that in some large estates, full tax forgiveness only occurs upon the death of the second spouse or the death of an heir, which emphasizes the need for long-term planning.

7. Case Study: Investor Transitions a Property to an UPREIT

Consider an investor who owns a commercial property worth $20 million with a low basis due to years of depreciation. Selling the property would trigger a substantial depreciation recapture tax. Instead, the investor contributes the property to an UPREIT, receiving OP units in exchange.

Through this contribution, the investor defers both capital gains and depreciation recapture taxes. The investor enjoys income from the UPREIT and gains liquidity from a diversified real estate portfolio. Upon their passing, the investor’s heirs may inherit the UPREIT units with a stepped-up basis, eliminating the capital gains and depreciation recapture liabilities – and has the liquidity option to immediately cash in or continue to hold some shares as a solid long-term investment. This case shows the strategic power of an UPREIT to manage tax exposure and create a tax-efficient transition of wealth to future generations.