How to 1031 Exchange into a REIT

Can You 1031 Exchange into a Real Estate Investment Trust (REIT)? Yes, but the process is complex and involves several steps. While some real estate professionals may argue that it’s not possible to use a 1031 exchange to invest in a REIT since they involve different forms of property ownership, it can be done with the right strategy.

To fully understand how it works, it’s important to first understand the basics of real property, 1031 exchanges, and REITs. While the exchange of real property is straightforward, REITs are more complex as they are a type of investment vehicle that allows investors to own shares in a portfolio of income-producing real estate assets. In general, REITs are required to pay at least 90% of their taxable income in the form of dividends to shareholders.

Despite the differences between real property and REITs, it’s possible to use a 1031 exchange to invest in a REIT. However, it requires careful planning and adherence to certain rules and regulations. Keep reading to find out more about the steps involved in completing a successful 1031 exchange into a REIT.

Defining Real Property and Securities: Understanding the Difference

Selling an investment property involves disposing of a tangible asset classified as “real property” by the IRS. The Internal Revenue Code Section 1031 allows investors to swap investment properties for “like-kind” assets held for productive use in trade, business, or investment. By reinvesting the entire sales proceeds in one or more similar properties within a specified time frame, investors can defer the accumulated capital gains taxes.

While REITs also deal with real estate, they follow a distinct investment structure. REITs acquire and hold a portfolio of real estate properties, with investors purchasing shares in the REIT instead of individual properties. Dividends, not rental income, generate cash flow, leading to REITs being categorized as securities rather than real property.

Since securities and real property are not like-kind assets, directly exchanging an investment property for a security will not fulfill the requirements of a tax-deferred 1031 exchange.

Making the Transition Through Exchanging

To move from owning real property to investing in a REIT, one option is to exchange your real property assets for shares of a Delaware Statutory Trust (DST). This can then be converted into ownership of Operating Partnership (OP) units via an Umbrella Partnership Real Estate Investment Trust (UPREIT).

If your end goal is a REIT investment, fractional ownership in a DST followed by conversion into an UPREIT may be the way to go. Many REITs offer UPREITs as a means for DST investors to convert their interests into OP units in the UPREIT. Because the conversion is made into a partnership, you can still defer capital gains taxes, unless you choose to convert your UPREIT OP units into REIT shares.

Converting your real property assets into shares of a Delaware Statutory Trust (DST) and subsequently into Operating Partnership (OP) units through an Umbrella Partnership Real Estate Investment Trust (UPREIT) can have both advantages and drawbacks.

• One of the potential benefits of this type of exchange is increased Real property assets are typically considered illiquid investments, but UPREIT OP units can provide liquidity if they are exchanged into REIT shares. However, it’s important to note that converting OP units into REIT shares may result in a taxable event.

• Another potential advantage of exchanging into an UPREIT is increased diversification. Rather than relying on a single property for cash flow, you can create a portfolio with potentially greater balance against economic volatility through an UPREIT investment.

• Additionally, converting your real property assets into UPREIT OP units can be an efficient estate planning The units can be passed down to your heirs on a stepped-up basis, which can eliminate accumulated capital gains taxes – unless the units are converted into REIT shares.

It’s important to consider the potential drawbacks of this type of exchange as well, such as the complexity of the process and the possibility of tax consequences if OP units are converted into REIT shares. As with any investment decision, it’s essential to consult with a qualified professional before proceeding.

How it Works

The UPREIT process involves two perspectives, those of the sponsor and the investor. Typically, a sponsor will place a high-quality asset from a REIT or a new acquisition into a newly formed Delaware Statutory Trust. During the syndication period, the DST offers predetermined equity to 1031 exchange and other investors. A pool of investors acquires beneficial interests in the trust and begins earning potential distributions similar to a standard DST investment. After satisfying the IRS safe-harbor guidelines for investment properties with a hold period of two to three years, the sponsor executes a Section 721 UPREIT on the property held under trust. At this point, investors can exchange their DST beneficial interests for operating partnership units in an entity owned by the REIT. Following a lockout period, investors can choose to redeem their OP units for common stock in the REIT or for cash, subject to terms established by the REIT.

Conclusion

For real property and DST investors, finding exit strategies can be challenging. However, the UPREIT structure offers a potential way for investors to increase liquidity and diversify their portfolios, although the process can be complex and take several years. It is worth noting that the benefits of the UPREIT structure may be outweighed by the inability to continue deferring capital gains tax liabilities through 1031 exchanges. Therefore, it may be useful for investors to seek guidance from a financial expert with expertise in DSTs, UPREITs, and REITs before considering exchanging real property assets for REIT shares.