Can you transition property into a Real Estate Investment Trust (REIT) using a 1031 Exchange? Yes, it is possible, but it requires a careful approach. While the IRS doesn't consider direct exchange into REIT shares as 'like-kind,' there are specific steps you can take to facilitate a successful exchange. This means that transforming investment property into a REIT via a 1031 exchange is feasible, but it must comply meticulously 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. However, with the right understanding and strategy, swapping your investment property for REIT ownership is indeed possible.
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." On the other hand, REITs invest in real property, but the investment structure is different. They buy real estate properties and hold them in a portfolio, and investors buy shares in the REIT rather than the properties within the portfolio. Distributions to investors are derived from dividends rather than rental income. Due to these differences, successfully completing a tax-deferred 1031 exchange involving a REIT requires a different approach.
Getting There By Exchanging
To transition from being a property owner to a REIT investor, you can exchange your real property assets for shares of a Delaware Statutory Trust (DST). Then, you have the option to convert ownership of DST shares into Operating Partnership (OP) units through an Umbrella Partnership Real Estate Investment Trust (UPREIT).
If a REIT investment is your final destination, fractional ownership in a DST and subsequent conversion into a UPREIT can be your next steps. Many REITs offer UPREITs as a way for DST investors to convert their DST interests into OP units within a UPREIT. By doing this, you can defer capital gains taxes, unless you decide to convert your UPREIT OP units into REIT shares.
There are potential advantages to this type of exchange, such as increased liquidity, portfolio diversification, and efficient estate planning. However, it's important to note that once you complete the UPREIT process, you can't 1031 exchange out of an UPREIT back into real property. Your investment must remain in the form of UPREIT OP units to continue deferring capital gains taxes.
How It Works
Here’s how the UPREIT process works from both the sponsor and investor perspectives:
- Typically, a sponsor places an institutional-grade asset from a REIT or a new 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. Investors acquire beneficial interests in the trust and begin earning distributions.
- 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, subject to terms laid out by the REIT.
The Bottom Line
Exit strategies can be challenging 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.
However, it's important to weigh the benefits against the fact that completing 1031 exchanges is no longer possible once you're in an UPREIT. Consulting with a financial expert experienced in DSTs, UPREITs, and REITs can provide valuable guidance for investors considering divesting real property assets for shares in a REIT.
Remember, this material is for general information and educational purposes only. It is not guaranteed as accurate or complete and should not be used as the primary basis for investment decisions. Consult with a qualified professional for advice tailored to your individual situation. Costs associated with a 1031 transaction may impact investor returns and outweigh the tax benefits. Investments always carry inherent risks, and there is no guarantee of income or receiving back the full initial investment.