Can you transition a property into a Real Estate Investment Trust (REIT) using a 1031 exchange? Yes, but it requires caution. While the IRS doesn't consider direct exchange of REIT shares as 'like-kind,' a sequence of steps that are followed can facilitate the successful completion of the exchange. This implies that transforming an investment property into a REIT via a 1031 exchange is feasible but entails meticulous compliance with IRS rules.
Some real estate professionals might say it’s impossible to 1031 exchange into a REIT since holding real property assets is different from holding shares of a REIT. The path between swapping your investment property for REIT ownership is complex but possible.
Keep reading to learn how it’s done – but first, let’s explain the nature of real property, 1031 exchanges, and REITs.
Defining Real Property and Securities
When you sell an investment property, you are disposing of a tangible asset that the IRS classifies as “real property." Internal Revenue Code Section 1031 (i.e., a 1031 exchange) allows investors to exchange investment properties for “like-kind” assets to be held for productive use in a trade or business or for investment purposes. You can defer any accumulated capital gains taxes by finding one or more similar properties and reinvesting the entirety of your sales proceeds. This is as long as you meet certain deadlines set forth by the 1031 exchange process.
REITs also invest in real property, but the investment structure is different. REITs buy real estate properties and hold them in a portfolio. Investors then buy shares in the REIT rather than the portfolio properties. Distributions to investors are dividends rather than rental income. The REIT management team also handles all aspects of property management and investment decision-making. That’s why REITs are defined as securities rather than real property.
To successfully complete a tax-deferred 1031 exchange involving a REIT, you can’t directly exchange out of your property and into a security since they aren’t like-kind assets.
Getting There By Exchanging
You can transition from being a property owner to a REIT investor by exchanging your real property assets for shares of a Delaware Statutory Trust (DST). You then can convert DST shares into Operating Partnership (OP) units through an Umbrella Partnership Real Estate Investment Trust, or UPREIT.
If a REIT investment is your final destination, consider fractional ownership in a DST and subsequent conversion into a UPREIT as your next steps. Many REITs offer UPREITs as a way for DST investors to convert their DST interests into OP units within a UPREIT. Since this conversion is being made into a partnership, you still can defer capital gains taxes – unless you convert your UPREIT OP units into REIT shares.
There can be some potential advantages and drawbacks to this type of exchange. Possible benefits could include:
- Liquidity. Real property assets aren’t considered liquid investments. However, your UPREIT OP units can become liquid if you exchange them for REIT shares. Keep in mind, though, that you will generate a taxable event.
- Diversification. Rather than having a single property providing cash flow, you can create a portfolio that is potentially more balanced against economic volatility. This is done through an UPREIT investment.
- Efficient estate planning. UPREIT OP units can be passed down to your heirs on a stepped-up basis, eliminating accumulated capital gains taxes (unless the units are converted into REIT shares).
The main issue to consider is that once you complete the UPREIT process, you are at the end of the line – you can’t 1031 exchange out of an UPREIT back into real property. Your investment must remain in UPREIT OP units to continue capital gains tax deferral.
How It Works
Here’s how the UPREIT process works from both sponsor and investor perspectives:
- Typically, a sponsor places an institutional-grade asset from a REIT or an acquisition into a newly formed Delaware Statutory Trust.
- The DST offers 1031 exchangers and direct investors a predetermined amount of equity during the syndication period. A pool of investors acquires a beneficial interest in the trust and earns distributions similar to those found in a standard DST investment.
- After a two to three-year holding period, which satisfies the IRS safe-harbor guidelines for investment properties, the sponsor executes a Section 721 UPREIT on the property held under trust. Investors then exchange their DST beneficial interests for operating partnership units in an entity that the REIT owns.
- After a predetermined lockout period, investors can redeem their OP units for common stock in the REIT or for cash. Redemptions are subject to REIT terms.
The Bottom Line
Exit strategies can be difficult for real property and DST investors. The UPREIT structure allows investors to potentially realize increased liquidity and portfolio diversification, although the road can be long and complicated.
Additionally, the inability to continue deferring capital gains tax liabilities by completing 1031 exchanges may outweigh the above benefits. Consulting with a financial expert with experience in DSTs, UPREITs, and REITs may benefit investors considering divesting real property assets for shares in a REIT.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
Costs associated with a 1031 transaction may impact investor’s returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.
All investments have an inherent level of risk. The value of your investment will fluctuate with the value of the underlying investments. You could receive back less than you initially invested and there is no guarantee that you will receive any income.
There is no guarantee that companies that can issue dividends will declare, continue to pay, or increase dividends.
A REIT is a security that sells like a stock on the major exchanges and invests in real estate directly, either through properties or mortgages. REITs receive special tax considerations and typically offer investors high yields, as well as a highly liquid method of investing in real estate. There are risks associated with these types of investments and include but are not limited to the following: Typically no secondary market exists for the security listed above. Potential difficulty discerning between routine interest payments and principal repayment. Redemption price of a REIT may be worth more or less than the original price paid. Value of the shares in the trust will fluctuate with the portfolio of underlying real estate. Involves risks such as refinancing in the real estate industry, interest rates, availability of mortgage funds, operating expenses, cost of insurance, lease terminations, potential economic and regulatory changes. This is neither an offer to sell nor a solicitation or an offer to buy the securities described herein. The offering is made only by the Prospectus.
Investors who 1031 Exchange into an upREIT have exchanged into a security and therefore no longer own real estate. Since the investor now owns a security, he or she cannot 1031 Exchange out of the upREIT and into other real estate. The sale or disposition of their interest in an upREIT will result in a taxable transaction, including the recognition of their deferred capital gain and any depreciation recapture. The upREIT also has control over the asset they 1031 Exchanged into and therefore has control over the sale or disposition of the asset. The sale or disposition of the asset can trigger the recognition of the investors deferred capital gain and any depreciation recapture. Some upREIT sponsors will guarantee that they will not trigger any taxable gain for a specified number of years, while others remain silent regarding the potential for triggering the deferred taxable gain.
