A question often asked these days is whether it’s possible to convert a 1031 exchange into a Real Estate Investment Trust, or REIT. The answer to that question is you can do a 1031 exchange into a REIT only if the right steps are followed.
Let’s first compare real property against securities.
When real property is sold, you dispose of your tangible real estate or what the IRS refers to as “real property.” A 1031 exchange enables you to trade or exchange “for property of like-kind, which is held either for productive use in a trade or business for investment,” as per the Internal Revenue Code (IRC) Section 1031 (a)(1). In simple language, this means if you’re doing a 1031 exchange to defer capital gains taxes, you need to identify one or more similar properties in which to invest, within a stipulated time frame.
Essentially, a REIT is a security, rather than real property. To qualify for tax-deferred exchange treatment under Section 1031, you can’t directly exchange out of your property into a security.
While investing in 1031 exchange REIT also handles real property; the investment structure is different. REITs typically purchase a lot of real estate properties and assimilate them into a portfolio. Investors purchase shares in the REIT, rather than the entire property, and their cash returns come from dividends, rather than rental income. An UPREIT is a unique REIT structure that allows investors to exchange their property for share ownership in the UPREIT.
The best part is you can change from a property owner to a REIT investor (without the tax gains) with help from the provisions under IRC’S Section 721, defined as “Nonrecognition of Gain or Loss on Contribution to a Partnership.” To facilitate this, you exchange out of your property into a Delaware Statutory Trust, which is usually controlled by the REIT. You then get the option to convert your ownership in the DST into shares for Operating Partnership (OP) units. This is done by investing in UPREITs or through an Umbrella Partnership Real Estate Investment Trust.
Let’s simplify this.
First, you exchange out of your real property into a DST that offers you a hassle-free tax-deferral option by giving you fractional co-ownership of real property. DSTs can offer diversification and monthly cash flow without unnecessary landlord obligations.
But, if investing in REITs is your final destination, the DST can be considered a stepping stone. UPREIT is the next step. Real Estate Investment Trusts offer UPREITs as a viable solution for investors and DSTs to exchange real estate shares into OP units. In the meantime, as an OP unitholder, you’re entitled to receive all the dividends from REITs.
For further queries, do check our FAQ section to get answers to all your 1031 exchange related questions.