Know the Consequences before You Invest.
A real estate investment trust (REIT) is a company that owns and operates a portfolio of income-generating properties. Like mutual funds, REITs pool the capital from numerous investors and pay out periodic distributions after first deducting all ongoing real estate and management expenses. Investors purchase shares in the company (like buying a share of stock in Apple) and do not actually own the underlying real estate. Investing in REITs appeals to investors who are seeking passive income from real estate investments. If the REIT is listed on a public exchange e.g., NASDAQ, NYSE, its shares can be more easily sold thereby providing a liquidity option to the investor.
Is it possible to invest 1031 Exchange funds into a REIT?
The technical answer which may surprise many investors is “NO” – at least not directly.
As many of our clients already understand, funds in an Exchange can only be reinvested in “like-kind” properties. Shares in a company are not considered “like-kind” and therefore direct investments into a REIT or any other company’s shares are not permitted.
Exchange funds however can be invested into properties which have been structured as a Delaware Statutory Trust (DST). Some DST sponsors have created a DST option that combines both DST and REIT structures over time. Investors in these types of offerings first invest in a DST and, later, the Sponsor will provide an option or in some cases mandate that the DSTs interests be acquired by an affiliated REIT via a tax neutral process called a 721 Exchange. If this serial process is correctly followed, the outcome for the investor is that they eventually end up with all their exchange funds now being invested in REIT shares.
So far, so good – but there can be an unfortunate “rest of the story” that all 1031 Exchange investors who are considering REIT investments must better understand before taking the plunge.
While no taxes are due when DST funds are first converted into REIT shares, the investor will lose the ability to complete a future 1031 Exchange with those funds. Upon future sale of the REIT shares, any accumulated capital gains taxes may need to be paid (see below for an important exception). This would include applicable Federal and State capital gains taxes, the 3.8% Net Investment (or Obama Care) Tax, and the often onerous 25% Depreciation Recapture Tax on all past deferred 1031 Exchange gains related to those funds - going back to the very first 1031 Exchange that you may have completed many years ago. The tax consequences can be considerable and, for many investors, rule out the 1031 into REIT strategy altogether.
A second consideration is that the dividend income from REIT shares is generally taxed as ordinary income and may potentially be subject to higher taxes than would be the case from income produced from rental properties or DSTs.
Despite these potential pitfalls, interest from 1031 investors to invest in DSTs with REIT share conversion options is on the increase. Why?
Two chief reasons:
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The average distributions from DSTs with REIT conversion options is generally higher than DSTs that do not have a conversion option. The underlying assets are often so-called “necessity retail” properties such as a CVS, Walgreen’s, Tractor Supply, etc. which often generate higher ongoing net cash flow than other assets such as apartments.
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The potential loss of the option to complete another 1031 Exchange may not be an issue if it is anticipated that the property interests will pass to one’s heirs during the holding period of the investment. When rental properties or DST interests pass to heirs upon the passing of a parent or spouse for example, the value of the interests is reset to current market value (called a “step-up in basis”) resulting in the elimination of all accumulated capital gains to that time. Therefore, there is no longer any tax to defer and a 1031 Exchange is not needed.
Section 721, like Section 1031, is a complex set of regulations and all readers are highly encouraged to seek advice from qualified tax advisors before making any final investment decisions.
For more information on Section 721, please download this helpful document.
For more information please feel free to contact us at info@firstguardiangroup.com or you can also schedule some time on Paul’s calendar here.
If you have completed the sale of your rental property and not yet identified a suitable replacement property and (very importantly!) identified at least one good back-up option, please contact us ASAP to explore 1031 options.
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We are open for business and stand ready to assist you with your exchange transaction. If you need a personal exchange consultation, we are happy to schedule a conference call at a time that works with your schedule and situation.
Please do not hesitate to contact us with your questions or concerns in these uncertain times. We look forward to hearing from you.
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