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Can You 1031 Exchange Into a REIT?

Martin Edwards, JD, CES®
01/22/24
This question has become increasingly popular on our live chat as individuals invested in real estate age and look to transition into passive real estate investments without tax consequences. Given that a REIT is a trust that primarily invests in real estate, it seems like you should be able to do so. After all, a 1031 exchange requires a property owner to sell real estate and exchange it for real estate. So far so good, right? Well, it isn’t quite that simple, which we will cover in this article.
Can you use a 1031 Exchange to reinvest into a REIT?

Review of 1031 Exchange Requirements

First, we must review the requirements set forth within IRS Code §1031. Although the nature of the REIT asset is real estate, the investor receives shares in the REIT which is treated as owning under a partnership and that is not compatible with IRS Code §1031 which effectively requires a more direct interest such as a deeded interest in real estate. So, without more, a real estate investor or business property owner cannot trade directly from the property into a REIT through a 1031 Exchange . However, if investment in a REIT is the ultimate goal, a property owner can accomplish such by first completing a 1031 Exchange into a DST and then completing a 721 UPREIT Exchange from the DST into a REIT, though careful consideration and planning are critical to the success of this process.

Tax Deferred Transaction into REIT

For real estate investors looking to move from a property into a REIT, one possible way to accomplish the movement with taxes deferred is via IRS Code §721, known as a 721 Exchange. REITs often hold the real estate assets in an Umbrella Partnership Real Estate Investment Trust, referred to as an “UPREIT.” If a property owner happens to own a significant piece of property that might meet the criteria of the type of property that a particular UPREIT owns in its investment portfolio, the REIT might be willing to acquire the property using a 721 Exchange for an equal value of operating units in the UPREIT operating partnership which can then shortly after be converted to direct shares in the REIT. But as one can imagine, a lot of things have to line up and your average property investor is unlikely to be able to take advantage of this structure due to their property not meeting all criteria set forth by the REIT.

1031 Exchange into a DST Followed by a 721 Transaction into a REIT

Fortunately for the average investor or business property owner who is unable to affect a trade directly with a REIT there is another practical solution utilizing a 1031 Exchange . Specifically, a property owner can use a 1031 Exchange and buy into a Delaware Statutory Trust (DST) as the Replacement Property . Although DSTs are very popular investments across the board for 1031 investors, in this case, the DSTs in questions are ones that are affiliated with the REIT sponsor.

This transaction is begun like any other 1031 Exchange where the Exchanger sells the Relinquished Property to the buyer of choice. The exchange proceeds are then utilized to acquire the DST, which is allowed per §1031 based on the legal structure of a DST interest. The investor is considered to be acquiring a direct interest in real estate, unlike a REIT where the interest being acquired is a partnership interest (and not real estate). As the link above explains in greater detail, the DST share holds a fractional share of one or more properties based on the amount invested, together with other people, but the investor does own his or her real estate interest personally. It is somewhat similar as a REIT, but one qualifies as Replacement Property for a 1031 Exchange and the other does not.

Once the DST interest is held for several years or more, the UPREIT 721 process described above can take place and the property owner can exchange the DST interest for the UPREIT interest via a 721 UPREIT Exchange. Basically, by using the DST, the REIT is able to acquire the property that fits into their REIT portfolio instead of the property originally being sold by the investor. Everyone can have their cake and invest it too.

Many property owners, simply trade into a DST and that is the end of that specific 1031 exchange transaction. From there they can continue to trade into future exchanges out of the DST. But from those interested in an ultimate investment in REIT, they can take the further step.

Considerations of 1031 Exchanges, DSTs and REITS

There are advantages to continuing to do 1031 Exchange s each time a property is sold to continue to defer the taxes that would otherwise become due, which among other things allows the investor to benefit from the time value of money. Additionally, should the investor pass away without having cashed out of their exchange property, the heirs would receive a stepped-up basis and any of the deferred taxes would become non-payable (https://www.accruit.com/blog/video-step-basis-1031-exchange).

REITs too have many benefits, but once the 1031 link is cut via the conversion to the REIT, any subsequent sale of the REIT shares are fully taxable at the basis carried over from the original exchange(s) - further tax deferral is not possible.

As always it is important to discuss tax deferral strategies and options with your CPA, Tax Advisor, or Financial Advisor to ensure you are making the most educated decision and that proper planning is in place.

 

The material in this blog is presented for informational purposes only. The information presented is not investment, legal, tax or compliance advice. Accruit performs the duties of a Qualified Intermediary , and as such does not offer or sell investments or provide investment, legal, or tax advice.