A Real Estate Investment Trust (REIT) is similar to a stock or bond mutual fund but instead of owning stocks or bonds, it owns real estate. REITs seldom own single family rentals but instead they invest in an institutional portfolio of properties that they periodically buy and sell opportunistically. For real estate investors it offers the benefits of a diversified portfolio that is professionally managed along with the assurance that the REIT will be distributing almost all of the net income to investors.
For those that follow REITs they know that REITs routinely utilize the 1031 provision when selling and then subsequently buying real estate or vice versa if they are doing a reverse 1031. This advantageous tax strategy at the entity or REIT level flows through to the investor at the individual level. Unfortunately, although a REIT can do a 1031 exchange at the entity level, individual REIT shares are considered personal property and do not qualify for a 1031 exchange since only real property qualifies. For tax deferral in a 1031 exchange, a taxpayer must exchange real property for other “like-kind” real property.
In this article we will discuss methods of doing a 1031 exchange or like-kind exchange into REIT shares by using section 721 exchange.
Can You Do a 1031 Exchange to REIT Shares?
Yes, but not directly. You have an intermediary step along the way. IRS 1031 exchange rules only permit exchanges of like-kind real estate property held for business or investment purposes. These exchanges can’t be made directly from real property exchange funds into securities such as Real Estate Investment Trust (REIT) shares. But they can go from a DST to a REIT.
In 2004, the IRS provided Revenue Ruling 2004-86, which defined the Delaware Statutory Trust structure (commonly known as a DST) as a like-kind investment for a 1031 exchange. This structure opens the possibility for an investor’s selling one property to exchange into a DST. And although this would become a two-step transaction, it is potentially the best way to achieve a REIT exit.
The first step of this transaction would give an investor title to the real estate through a beneficial interest in the trust, qualifying as a regular 1031 exchange. By diversifying an exchange into multiple DST offerings, an investor is now one step closer to owning shares in a REIT.
The second step of this transaction would occur at the liquidation of the DST investments and the sponsor’s successful completion of a 721 exchange, also known as an UPREIT. The DST property can later be contributed into an UPREIT structure under Section 721, allowing the taxpayer to ultimately acquire OP Units that are essentially the equivalent to an interest in the REIT itself.
So, if you own real estate and want to sell it tax smart, you 1) sell your property and 2) have the proceeds go to a Qualified Intermediary as always, then you 3) rollover the sales proceeds into a DST that is destined for a 4) REIT after a few years. Once it ends up at the REIT, you own OP Units in the REIT, which is the equivalent of saying you own shares in the REIT, you’ve paid no taxes initially or upon conversion, you can now sell or gift some or all units in the REIT and only pay taxes if you sell. If you never sell, upon death, your beneficiaries get the stepped-up cost basis.
What Happens After Doing a 1031 Exchange into a REIT?
Once you do the section 721 conversion into the REIT, you can NEVER do another 1031 exchange again with that equity. Additionally, if you sell your shares in the REIT, your realized gains are automatically subject to the various federal and state taxes. Before doing a 1031 exchange into a DST and then into a REIT, you should endeavor to read the memorandum or prospectus and consult with your tax and legal advisors regarding your specific situation.
The reasons people like 721 exchanges are because they gain liquidity or access to their capital which is not the case with stand-alone DSTs, they also like the flexibility it presents for estate planning, the built in institutional diversified portfolio that in theory should outperform a portfolio of DSTs and the fact that they don’t have to find a replacement property every 5 years or so. The only reason to avoid a 721 is because you can never do another 1031 exchange and so if the REIT you end up owning is a dog or turns out to be a lousy investment then selling triggers a tax.
What does this mean to you? Sera Capital has known about tax smart DSTs that can convert to REITs for quite some time. We have never recommended them until recently. We felt that stand-alone DSTs were better. But the industry and sponsors have changed. The reason we’ve started looking favorable on a portion of people’s portfolio ending up in a REIT is because the quality of the ultimate REIT destination has dramatically increased over the last few years. Your final destination REIT is now more predictable which is a necessity if you are to be wedded forever.
How Sera Capital Can Help With 1031 Exchanges
First, we always recommend that any investor talk with a CPA or tax attorney who is knowledgeable about 1031 Exchanges. Our experts can give you the most up-to-date details regarding each investment strategy and help you find the option that works best for you and your family.