There are many ways to be involved with real estate ownership. There is direct ownership, which involves hands-on management and decision-making. Then there is passive ownership, including Delaware Statutory Trusts (DSTs) or real estate investment trusts (REITs).
It’s possible to swap investment real estate you own into a DST through a 1031 exchange as an exit strategy from direct investment (and to potentially defer capital gains taxes). In certain situations, it’s possible to trade those DST shares for REIT shares through an Umbrella Partnership Real Estate Investment Trust or UPREIT. However, this conversion is a taxable event, triggering capital gains taxes and depreciation recapture.
The above actions are complex and require due diligence when analyzing the targeted DST and REIT. Part of that research should focus on financial statements.
From Property to DST to REIT
You could contribute real estate to a REIT through a UPREIT (also called a 721 exchange). You could exchange that real estate for DST shares through a 1031 exchange. But you can’t directly exchange DST shares for REIT shares through a 1031 exchange. This is because REIT shares aren’t considered like-kind property under IRS rules.
However, if the DST in which you’ve invested has prearranged the option to be taken over by a REIT, it’s possible investors may participate in an UPREIT conversion. Here’s how this might work:
- You exchange your investment real estate (relinquished property) for DST shares of equal or greater value to the property you sell through a 1031 exchange.
- The DST has an agreement to be absorbed by a REIT through a 721 exchange.
- DST shares are exchanged for operating partnership (OP) units in the trust.
- You can later convert the OP units into REIT shares or cash later, triggering a taxable event.
The potential benefits of these exchanges and conversions are the potential deferral of capital gains taxes, better chances for liquidity, and possible access to institutional-grade investment real estate.
Examining the Financials
When performing due diligence, you can examine the following to determine the financial health of a targeted DST and the REIT that might absorb it.
DST information
When analyzing a DST, consider the following:
- Fees and costs: acquisition, management, closing costs, disposition fees, and financing costs and how they might impact your rate of return.
- Property performance: after-tax cash flow, market trends, tenant lease terms, net operating income, debt structure, occupancy rates, and cap rates.
- Sponsor experience: track record, geographic/asset knowledge, real estate knowledge.
- Risk Considerations: Investors should evaluate how the DST’s investment strategy aligns with their risk tolerance, liquidity needs, and long-term financial goals.
It’s also a good idea to consider how the DST’s strategy fits in with your risk tolerance.
REIT financials
When analyzing the REIT involved with a section 721 exchange, focus on operating and financial performance metrics (including occupancy, NOI growth, and dividend payout ratio). You should also pay attention to other financial information from the:
- Balance sheet: assets, liabilities, shareholder equity through real estate holdings, debt levels, and operating partnership units
- Income statement: rental income, property expenses, net operating income, interest expense, depreciation, and amortization
- Statement of cash flows: cash and cash equivalents, funds from operations (FFOs), investment and financing activities, and investor distributions
The Takeaway
Moving your investment real estate into a DST, then a REIT, is a complex process, requiring timing, adherence to the rules, and plenty of due diligence. Much of that research should focus on track records and financial metrics of both the DST and REIT. You should also retain the services of a tax advisor and attorney as your guide. These steps can support your investment strategy (and potentially help you realize tax benefits) while avoiding costly mistakes.
The tax and estate planning information offered by the advisor is general in nature. It is provided for informational purposes only and should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.
