For many real estate owners, selling their property outright is a non-starter. Not because they don’t want to cash out, but because of the significant tax consequences that come with it. Capital gains taxes, depreciation recapture, and estate planning considerations often make an outright sale an unattractive option. I have seen many scenarios where a generation of tax depreciation, coupled with cash-out refinancing, has the left the owners with a deferred tax bill that can eat up anywhere from 50% to 100% of the proceeds from a sale. However, a REIT can provide a structured, tax-efficient exit strategy that allows owners to unlock liquidity while maintaining control over the timing of their tax exposure.
The §721 Tax-Free ‘Merger’: Deferring the Tax Bill
One of the most powerful strategies for a tax-efficient exit is a §721 exchange, also known as an UPREIT contribution. Instead of selling outright and triggering immediate capital gains taxes, an owner can contribute their real estate to a REIT’s operating partnership in exchange for Operating Partnership (OP) units. This structure allows for a tax-deferred transfer, meaning the owner avoids capital gains and depreciation recapture at the time of contribution. In return, the owner now holds a diversified interest in a professionally managed real estate portfolio without the burdens of property management or loan guarantees.
§733 Partial Redemption: Access to Liquidity Without a Large Tax Hit
After a lockout period, typically two to three years, OP unit holders can receive a non-liquidating cash distribution from the REIT under §733. Unlike a traditional §1031 exchange, which requires reinvesting in another property to maintain tax deferral, a non-liquidating §733 distribution provides owners with the flexibility to access liquidity on their own schedule. Unlike a 1031 exchange, where the first dollar of boot is full taxes as gain, with a non-liquidating redemption, the first dollar simply reduces basis and so long as there is still basis, that distribution can be tax free.
Using Loss Harvesting to Offset Gains
A major advantage of owning OP units (or REIT shares) when compared to a single property is the ability to use tax-loss harvesting to minimize taxable gains. If an investor redeems OP units or sells REIT shares, they can offset some or all of their capital gains by selling other underperforming investments at a loss. This strategy is particularly useful in years where the market experiences downturns, allowing investors to strategically manage their overall tax exposure. Direct property ownership, on the other hand, does not offer the same level of flexibility—once a sale occurs, taxes are due unless a 1031 exchange is completed.
Estate Tax Discounts on REIT Shares
When a real estate owner holds property directly, it is typically valued at full fair market value for estate tax purposes. However, when an owner holds REIT shares or OP units, those interests may qualify for valuation discounts due to minority ownership and lack of marketability. These discounts can significantly reduce the taxable value of an estate, lowering potential estate taxes for high-net-worth individuals. By transferring ownership into a REIT structure before passing the assets to heirs, property owners can create a more tax-efficient estate plan while still benefiting from continued cash flow and appreciation.
The Ultimate Exit: Basis Step-Up and Full Liquidation
For owners looking to pass their wealth to the next generation, one of the most significant tax advantages of a REIT structure is the basis step-up upon death. When heirs inherit OP units or REIT shares, the cost basis is stepped up to the fair market value at the time of inheritance. This means that if the heirs decide to sell, they owe no capital gains tax on the appreciation (or tax depreciation) that occurred during the original owner’s lifetime. This is one of the most effective ways to eliminate deferred tax liabilities, making the REIT structure a smart long-term strategy for real estate investors focused on wealth preservation.
Additional Benefits Beyond Taxes
Beyond tax efficiency, a REIT partnership offers several other advantages compared to direct property ownership. Diversification reduces the risk associated with owning a single property, as REITs typically hold a portfolio of assets across various markets. No loan guarantees mean that owners no longer have personal liability tied to mortgage debt. Professional management ensures that properties are operated efficiently, eliminating the burdens of leasing, maintenance, and tenant management. Together, these benefits create a compelling case for real estate owners looking for a tax-free transition out of direct ownership while still maintaining an interest in high-quality real estate investments.
A Smarter Exit Strategy
For property owners reluctant to sell due to taxes, a REIT partnership offers a structured, strategic solution. By leveraging a §721 exchange, §733 partial redemptions, loss harvesting, estate tax discounts, and basis step-up strategies, owners can unlock liquidity while minimizing their tax burden. At the same time, they gain access to diversification, professional management, and the ability to control the timing of their liquidity events. Instead of being forced into an all-or-nothing decision, a REIT provides a flexible, tax-efficient way to transition out of real estate ownership on your own terms.
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