Many investors that are in a 1031 exchange that are tired of actively managing their investment properties and are looking to diversify their 1031 exchange eligible equity as opposed to buying a single property again often ask themselves, “Can I 1031 exchange into a REIT?” The answer is yes—not directly—but indirectly, as part of a multi-step process.
However, it’d be important to first understand what exactly an REIT is before we deep-dive into the 1031 exchange investments and different approaches for a 1031 exchange into a REIT.
What is an REIT?
A Real Estate Investment Trust (REIT) is an organization that owns, operates, or finances real estate with the goal of producing income. How does it work exactly? Big and small investors purchase assets or own shares in the company and are rewarded with dividends collected from the income generated from the real estate properties owned by said company. REIT companies manage high-priced real estate properties and collect the rent which is then distributed to shareholders in the form of income dividends.
Although REIT investors don’t own a piece of the real estate, they possess shares in the company, which provides them an opportunity to reap rich dividends by investing in high-value real estate. The double benefit is that they get to earn income from their investment while simultaneously seeing their capital appreciate.
The two primary types of REITs are public and private-placement REITs. As their names suggest, public REITs are publicly traded while private-placement REITs are not traded on a stock exchange and sold only to accredited or institutional investors. Naturally, public REITs investments offer more liquidity in comparison to private-placement REITs.
How Can You 1031 into a REIT?
An investor is not able to do a direct 1031 exchange into a REIT since REIT shares are not considered “like kind” property by the IRS for the purposes of a 1031 exchange. However, the investor may purchase an interest in a Delaware Statutory Trust – DST property – via a 1031 exchange thanks to the IRS’ Revenue Ruling in 2004. To elaborate further, the IRS presented the Revenue Ruling 2004-86 in 2004, which declared that the DST is an investment of like-kind for a 1031 exchange, opening the doors to a DST exchange for investors selling one type of property for another. It’s one of the best methods for a conversion from 1031 into REIT.
In certain DSTs, after the investor purchases the DST interest and time passes, the DST (and the real estate in it) could be called into the REIT as part of its business plan and the investors could utilize a section 721 exchange to exchange their DST interests, on a tax deferred basis, for shares of the REIT’s operating partnership (also known as OP Units). The OP Units are typically convertible on a one-for-one basis with the REIT’s common stock. It should be noted that this strategy is not part of every DST’s business plan, and if it is, there are no guarantees that the exit would be through an UPREIT/721 exchange.
Now the investor has deferred his/her taxes via the 1031 into a DST and via the 721 from the DST into the REIT. Now that this explanation has answered the “Can I 1031 Exchange into a REIT” question, we must explore some often left out implications investors must be aware of.
Difference between Real Estate and REIT
Real property or real estate like a residential house or commercial building is tangible and generates rental income. On the other hand, a Real Estate Investment Trust or REIT offers a different type of investment opportunity, similar to stocks. In essence, an REIT is categorized as a security and not real or tangible property.
REITs purchase and add several real estate properties to their portfolio. However, the main difference between real property and REIT investments is that in the latter, investors do not buy any stake in the real estate or property. Instead they buy shares in the REIT and earn income in the form of dividends and not rental income. So in that sense, do REITs qualify for a 1031 exchange? Not necessarily – this key difference between an REIT and real property makes the 1031 property exchange into an REIT for tax deferral purposes a little challenging. Therefore, to convert from a 1031 exchange into an REIT to defer your taxes, the route is relatively complex and cumbersome, in comparison to the 1031 DST exchange.
How to 1031 Exchange into a REIT?
Real estate investors quite commonly use the IRC Section 1031 investment opportunities to defer capital gains taxes when exchanging their property into a DST. However, another provision offered under the tax code – IRC Section 721 – allows investors to convert their real estate into REIT units while avoiding capital gains taxes – surprisingly hasn’t yet caught the attention of investors. The Section 721 is defined as the “Non-recognition of Gain or Loss on Contribution to a Partnership”.
To take advantage of the 721 code, investors can contribute their property to an REIT’s Operating Partnership (OP) – the entity through which an REIT typically purchases and owns its properties. However, they don’t get a stake in the several properties included in the REIT’s portfolio, instead they get Operating Partnership Units which are equivalent to REIT shares.
The OP Units are typically convertible on a one-for-one basis with the REIT’s common stock. So now the seller has the option of converting their REIT units into shares, while simultaneously taking advantage of the tax deferral. It’s also referred to as an Umbrella Partnership Real Estate Investment Trust (UPREIT).
Thus the investor has deferred his/her taxes via the 1031 into a DST and via the 721 from the DST into the REIT. Now that this explanation has answered the “Can I 1031 Exchange into a REIT” question, we must explore some advantages as well as often left out implications investors must be aware of.
Benefits and Drawbacks of 1031 Exchange into a REIT
A 1031 exchange into a REIT comes with its fair share of benefits as well as critical drawbacks.
Benefits of 1031 Exchange REIT
First let’s examine the benefits, which include the following:
- Inheritance on a Stepped-Up Basis
Investors can take advantage of diversification to lower their risk as the 1031 exchange into an REIT allows them to diversify their single property investment into OP units of the REIT, which owns multiple properties. Instead of owning a single property with a single cash flow in the form of rental income, they can now, with the help of Section 721, own OP units, which generate cash flows from a diversified portfolio. The economic gains from an REIT can be tremendous owing to the distributions of potential monthly operating income, potential capital appreciation, and property diversification. But of course it depends on the extent of diversification, which varies case by case depending on the portfolio of the chosen REIT.
Real property is illiquid but not OP units as they offer investors the option to convert them into REIT shares. Of course it would incur taxes but only on the OP units that have been exchanged, so investors can choose to exchange just a portion of their OP units into REIT shares to limit the taxable gains.
For those investors who’re planning to bequeath their UPREIT OP units, they can do so with a step-up on tax basis so their heirs won’t have to pay capital gains taxes. In addition, investors can fully divide their OP units among their heirs allowing a more efficient estate planning approach.
De-merits of 1031 Exchange REIT
The drawbacks of a 1031 exchange into a REIT can be quite significant too, which are discussed below:
- Eliminates the Possibility of a REIT or UPREIT Back into Real Property
- Potential Economic Risks
Upon successful completion of the 1031 into a REIT, the investor doesn’t have the option to convert it back into 1031 to defer taxes. That is, once an investor does the section 721 conversion into the REIT, he/she can NEVER do another 1031 exchange again with that equity.
The only way forward is to convert their OP units into REIT shares and pay the capital gains taxes because the second they sell their REIT shares, they are immediately taxable. So, all of the Federal Capital Gains (15-20%), State Capital Gains (0-11.3% depending on the state he/she lives in), Depreciation Recapture Tax (25%), and the Medicare Surtax (3.8%) will now be due upon sale. This final tax bill for many investors may be very large due to the investor having utilized 1031 exchanges for many years and the tax bite could potentially be significant. After learning this fact, many of our clients seriously consider whether the 1031 exchange into a REIT would be a worthwhile endeavor.
It should be noted that many Non-Traded or private REITs often are not liquid— something to think about for many investors as they consider potential prospects for their real estate holdings/tax-deferral expectations, etc. An investor would have to be comfortable with never doing a 1031 exchange again and would also have to acknowledge the potential reality of paying taxes upon sale of the REIT shares. Our investors have often decided that the risk of Non-Traded REITs and their spotty track records (although some have done well for investors) is not worth the exercise.
Another demerit of the 1031 exchange into a REIT is that the economic viability of each REIT is naturally subject to its portfolio and the management team’s decisions which may impact the returns generated by the properties. In addition, if the REIT is publicly traded on a stock market, naturally it becomes susceptible to stock market volatility.
1031 REIT Exchange May Be Out of Reach of Small Investors
A vital factor that has partly contributed to the limited use of the Section 721 code in comparison to that of the Section 1031 is that most REITs typically acquire properties of only institutional quality. Therefore the 721 option for 1031 exchange into an REIT is not open to small-scale investors. However, with the help of two different models, the 721 exchange route may become available to individual small investors too.
- In the first model, a REIT removes one of its institutional quality buildings from its portfolio and makes it available to smaller investors who want to convert it into a 1031 exchange. They can hold the title to it either as a Tenant in Common (TIC) owner or as a beneficial interest in a DST. Later the investors can contribute their DST interests in the building into the REIT OP in exchange for OP Units while deferring their taxes. The open path to convert into OP Units is made possible by the two to eight-year call option levied on the building by the REIT.
- In the second model, an investor can offer their property to the REIT for evaluation. Only if the REIT determines that the owner’s selling value is reasonable, the investor can contribute their property to the REIT with the help of Section 721.
Both the models offer a win-win. The REIT is able to gather more capital for their trust whereas the investor gets the opportunity to convert into a REIT and take advantage of its economic gains and diversification along with the tax deferral of course.
The articles below show published examples of the risks of investing in Non-Traded REITs: