First of all, cashing out in an UPREIT is possible, and Section 733 is very favorable - but it takes very careful planning and the more you redeem, the more accurate you have to be.
Under § 733, a partner’s outside basis in the partnership is reduced by the amount of money (or property) distributed to them in a non-liquidating transaction. For an UPREIT, where the partnership holds real estate assets, these distributions may include cash, property, or the assumption of liabilities.
A key feature of § 733 is that no gain is recognized unless the total distributions (including cash and deemed distributions from liability relief) exceed the partner’s outside basis in the partnership interest. If the distribution exceeds this basis, the excess is treated as a taxable gain under § 731(a).
The Role of Debt Basis in Real Estate Partnerships
In an UPREIT, partners typically have debt basis, which represents their share of the partnership's liabilities under § 752. Debt basis plays a critical role because it:
Increases Outside Basis: A partner's share of partnership liabilities is added to their outside basis.
Reduces Taxable Gain: Higher outside basis allows for larger distributions without triggering gain recognition.
For real estate partnerships, liabilities often include nonrecourse debt, allocated based on partners' profit-sharing ratios, and recourse debt, allocated to the partners bearing the economic risk of loss. Changes in these allocations can significantly impact a partner’s tax position during a partial redemption.
How Does a § 733 Redemption Work in an UPREIT?
Reduction in Ownership Percentage:
In an UPREIT, a partial redemption usually reduces the partner's ownership interest, which in turn decreases their share of partnership liabilities. This liability reduction is treated as a deemed cash distribution under § 752(b).
Total Distribution Includes Liability Relief:
The total distribution in a § 733 redemption is the sum of actual cash or property distributed plus the deemed cash distribution from liability relief.
Basis Reduction and Gain Recognition:
If the total distribution exceeds the partner's adjusted outside basis (including debt basis), the excess triggers taxable gain under § 731(a). Otherwise, the partner simply reduces their outside basis by the amount of the distribution. Practically speaking, this means that for each $1 redeemed, you eat up your basis by $1, but also lose additional debt basis (maybe another $1 depending on debt levels).
Example: Partial Redemption in an UPREIT
A partner owns 20% of an UPREIT and has:
Outside basis: $500,000 (includes $200,000 of debt basis).
Share of liabilities: $200,000.
Transaction:
The UPREIT redeems half of the partner's interest, reducing their ownership to 10%. This reduces their share of liabilities from $200,000 to $100,000, a $100,000 deemed cash distribution under § 752(b). The partner also receives $300,000 in cash.
Tax Result:
Total distribution = $100,000 (debt relief) + $300,000 (cash) = $400,000.
Basis adjustment = $500,000 (original outside basis) - $400,000 (distribution) = $100,000 remaining basis.
No gain is recognized because the total distribution does not exceed the partner's outside basis.
Alternative Example
If, on the other hand, the partner has $300,000 outside basis ($200,000 debt basis), the transaction would trigger $100,000 in gain. Basis adjustment = $300,000 (original outside basis) - $400,000 (distribution) = $100,000 in gain. This would also result in the partner have $0 outside basis. This is important because any future distributions or further liability reductions could trigger additional taxable gains since the partner’s basis is now fully depleted.
Potential Pitfalls and Planning Opportunities
Reduction in Debt Basis:
When a partner’s share of liabilities decreases significantly, they may face a deemed cash distribution large enough to trigger taxable gain. Planning to adjust liability allocations or contributing additional basis (e.g., cash or property) can help offset this issue.
Nonrecourse Debt Considerations:
Nonrecourse debt is subject to unique allocation rules under Reg. § 1.752-3, including allocations tied to minimum gain and § 704(c) gain. These rules can amplify the impact of a partial redemption.
Long-Term Tax Deferral:
By carefully structuring the partial redemption, partners can defer gain recognition until they exit their remaining interest, maximizing the benefits of the UPREIT structure.
What to do Now:
A § 733 partial redemption in an UPREIT is a tax-efficient mechanism for partners to receive cash in a tax-efficient manner, but it comes with complexities, particularly around debt basis and liability allocations. To avoid unexpected gain recognition, partners should:
Understand their outside basis, including debt basis.
Anticipate changes in liability allocations.
Strategize distributions with a tax pro (high level) to maximize tax deferral.
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