Real Property vs. 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.
1031 Exchange REIT
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.
There are many other benefits to such an exchange.
Liquidity. As you know, your real property isn’t liquid. However, your OP units are, if you wish to exchange them into REIT shares. Remember that doing so will lead to a taxable gain, but only on the OP units your exchange. So you can watch your capital gains and pay them when you choose to!
Diversification. Instead of a single property providing cash flow, an UPREIT investment gives you cash flow from a portfolio that is precisely balanced against economic volatility.
Efficient estate planning. UPREIT OP units can be transferred to your heirs on a stepped-up basis. This removes capital gains taxes (unless the units are converted into REIT shares) while providing your heirs with continued dividends.
For further queries, do check our FAQ section to get answers to all your 1031 exchange related questions.
To know more about 1031 Exchange REIT, you can speak to one of our advisors on 888-993-2835 or email us at email@example.com.