Is it possible to leverage the benefits of a 1031 Exchange to transition into a Real Estate Investment Trust (REIT)? Contrary to popular belief, the answer is a resounding yes! Although the Internal Revenue Service (IRS) does not consider direct REIT share acquisitions as ‘like-kind’ to real estate properties, there is a specific sequence of steps that can make this move not only possible but advantageous. This means that if you’re interested in converting your investment property into a REIT, meticulous compliance with IRS regulations is crucial.
Understanding the Landscape: Real Property vs. Securities
When you offload an investment property, you’re parting ways with a tangible asset classified by the IRS as “real property.” The 1031 Exchange, defined in the Internal Revenue Code Section 1031, allows you to trade this asset for “like-kind” properties, thereby deferring capital gains taxes. This is accomplished by reinvesting the full sales proceeds into one or more similar properties within specific deadlines dictated by 1031 Exchange rules.
In contrast, REITs also specialize in real property but are fundamentally different. These trusts hold a portfolio of properties, and investors buy into these portfolios through shares. The income generated comes from dividends, not rental income, and all property management aspects are taken care of by a management team. Because of these differences, REITs fall under the “securities” category.
The Pathway to REIT: How to Navigate the Exchange
Here’s where things get intriguing. To successfully transition from a real property owner to a REIT investor, consider using a Delaware Statutory Trust (DST) as your gateway. First, exchange your real property for shares in a DST. Then, through an Umbrella Partnership Real Estate Investment Trust (UPREIT), you have the option to convert these DST shares into Operating Partnership (OP) units.
Why Should You Consider This?
- Liquidity: DST shares can be converted into REIT shares, making your investment more liquid. But remember, doing so creates a taxable event.
- Diversification: UPREIT investments allow you to spread your risks and create a more economically resilient portfolio.
- Efficient Estate Planning: UPREIT OP units can be handed down to heirs on a stepped-up basis, thereby eliminating capital gains taxes unless converted into REIT shares.
Remember, once you journey through UPREIT, there’s no turning back to real property through a 1031 Exchange. The capital gains tax deferment applies only as long as your investment remains as UPREIT OP units.
Mechanics of UPREIT: A Dual Perspective
- From the Sponsor’s End: Typically, a sponsor integrates an institutional-grade asset into a newly formed DST. This trust then opens up to 1031 exchangers and direct investors for equity investment during the syndication period.
- From the Investor’s End: Once part of the trust, investors earn distributions much like those in a standard DST. After meeting IRS guidelines for a 2-3 year holding period, the asset undergoes a Section 721 UPREIT, allowing investors to switch their DST interests for OP units in a REIT-owned entity.
After a designated lockout period, these OP units can be exchanged for REIT common stock or cash, depending on the REIT’s terms.
Navigating from real property or DST to a REIT via UPREIT is a complex yet rewarding venture. It offers benefits like liquidity and diversification but also comes with its limitations, such as an irreversible exit strategy. If the allure of REITs has captured your interest, make sure to consult a financial expert with experience in DSTs, UPREITs, and REITs to assess the feasibility and benefits tailored to your financial landscape.
Ready to Take the Next Step?
Seize this unique opportunity to diversify your real estate investments while maintaining capital gains tax deferral advantages. Reach out to one of our REIT investment advisors well-versed in 1031 Exchanges and REITs to plan your tailored investment journey today.