Investors often purchase real estate looking for benefits such as diversification and income. However, at some point, the time and energy needed to actively manage rental properties may become too much.
It’s common for property investors to wonder whether there’s an opportunity to maintain exposure to the real estate market without the need for hands-on management. In this case, exchanging an investment property into a Real Estate Investment Trust (REIT) could be a viable solution.
However, the process can be a bit complex. A 1031 exchange requires the exchange of an investment property into a “like-kind” replacement property. Since the IRS does not consider a REIT to be like-kind to physical real estate, a direct exchange isn’t possible. Instead, it’s necessary to complete a multi-step process.
This short guide provides an overview of the investment structures used in the process and the steps required to defer your capital gains taxes while exchanging an investment property into a REIT.
A Real Estate Investment Trust (REIT) is a company that deals with income-producing real estate. Since the REIT company handles all the property management, this is considered a passive real estate investment.
Investors provide a pool of assets, which the REIT uses to purchase a portfolio of properties. Instead of owning the underlying properties, REIT investors own shares of the REIT.
Rents collected from tenants are distributed to shareholders in the form of income dividends, rather than as rental income. This is part of the reason why REITs are considered securities, rather than real property, and why they do not qualify as like-kind replacements for a 1031 exchange.
A Delaware Statutory Trust (DST) is a legal entity created under Delaware state law for the purpose of conducting business. Like a REIT, DSTs purchase and manage income-producing properties. The DST holds 100% of the interest in the real property while investors acquire a beneficial interest in the trust. Investors have limited personal liability for the underlying assets and receive a portion of the income the properties produce.
One major difference between DSTs and REITS is that under IRS rules, DSTs are considered a like-kind property and can be used as a replacement property for a 1031 exchange.
Investors seeking the tax advantages of a 1031 exchange can replace a physical property with a REIT by carefully completing the following multi-step process.
One critical rule regarding a 1031 exchange is that the property owner must not take possession of the proceeds from the initial property sale. This makes it necessary to use a qualified intermediary (QI) when you sell your property.
Once you’ve sold your property to a third party, your QI will hold the sales proceeds for you and facilitate the remainder of the exchange.
Next, you’ll have your QI use the funds from the sale of your relinquished property to purchase beneficial interests in a specific type of DST that has been planned for eventual sale to a REIT that is typically owned by the same DST sponsor company. Upon purchase, investors will acquire a beneficial interest in the trust which, per IRS tax code (2004-86) will be regarded as equivalent to holding title in the property.
Just like with any other type of 1031 exchange, you must identify the DST you plan to purchase within 45 days from the date you sold your relinquished property and close on the purchase within 180 days. If these and all other IRS requirements have been met, your transaction should qualify as a 1031 exchange, allowing you to defer your capital gains and depreciation recapture taxes.
The final step of the transaction occurs when the DST is sold in the future, and the sponsor first completes a conversion of the investor’s DST interests into Operating Partnership Unit (OP Units) in the REIT. This conversion process is referred to as a 721 exchange into a structure known as an Umbrella Partnership Real Estate Trust (UPREIT).
Following a predetermined lockout period, you’ll have the chance to redeem your OP units for common stock in the REIT or for cash. It is important to note that if you sell your REIT shares, you will no longer be able to defer taxes and any gains that have been previously deferred via past 1031 exchanges that you have completed related to the investment will be subject to taxes.
To continue deferring your capital gains, your investment must remain in the form REIT ownership interests and not be sold. When REIT interests are passed along to heirs or successors upon the passing of the owner, they will receive a “step up in basis” and capital gains obligations will be forgiven and reset to then market values.
You also can’t complete a 1031 exchange from an UPREIT back into real property, so this would be “the end of the line” for 1031 exchanges related to that investment.
As you can see, completing a 1031 exchange into a REIT isn’t exactly a simple process. To avoid inadvertent and possibly costly mistakes, consider consulting with a team of professionals including tax and investment advisors. If you would like to start exploring your options, contact our team to schedule a consultation.