A real estate investment trust (REIT) is an excellent investment option for investors who like the cash flow from real estate but don't want any of the management responsibilities. Many real estate investors want to know if they can move into this type of passive investment by doing a 1031 exchange into REIT shares.
We'll look at the basics of how a 1031 exchange works and what exactly a REIT is and then show you what options are available.
Understanding a 1031 exchange
A 1031 exchange is a popular method real estate investors use to defer their capital gains tax when selling an investment property. Instead of cashing out and paying the taxes, the investor follows a set of rules in IRC Section 1031 to purchase a new property with the proceeds.
Using a 1031 exchange is an excellent tax strategy used to trade up to larger properties and increase the return on investment (ROI) from real estate.
A 1031 is a like-kind exchange. This means that the replacement property and the relinquished property have to be real property used in business or used as an investment. So an apartment building can't be exchanged for a primary residence or another type of investment, like stocks.
You can learn all about 1031 exchanges in our 1031 Exchange Basics guide.
What exactly is a REIT?
REIT stands for real estate investment trust. A REIT is a company that owns or finances income-producing real estate. Investors pool their money to purchase assets and receive income in the form of dividends. REIT investors don't own a piece of the real estate itself. Instead, they own a share in the company.
There are many different types of REITs that invest in certain types of assets. However, we're just going to briefly look at the two main categories of REITs:
- Public REITs.
- Private-placement REITs.
Most REITs are publicly traded, which makes them a lot easier to invest in than the actual real estate assets themselves. Publicly traded REITs also offer the benefit of being a highly liquid investment since they can easily be bought and sold like stocks.
There are also public REITs that are not traded on a national stock exchange. These are still registered with the Securities and Exchange Commission (SEC) but aren't easily bought and sold on an exchange like other stocks. Shares in a public non-listed REIT (PNLR) have limited liquidity since they're limited to being sold on a secondary market or through a repurchase program where the REIT will buy back the shares under certain conditions.
There are also private REITs, which don't trade on a stock exchange and are exempt from SEC registration. Unike publicly traded REITs, shares in a private placement REIT are typically only sold to institutional investors or an accredited investor. Since they don't trade on a stock exchange, they don't have the same liquidity as public REITs.
Whether a REIT is public or private, investors don't have any direct ownership of the real estate. Instead, they own a share of the company that owns the real estate. This means that investors own securities, not real property.
The difference between real property and securities
Here comes the obstacle for purchasing shares in a REIT with the proceeds from a 1031 exchange. As mentioned earlier, the replacement property also has to be real property held for business or investment. Since REIT investments are securities, they don't meet the requirements as a replacement property for a typical 1031 exchange.
Real property is a tangible asset. You can visit it, look at it, and touch it. Securities, on the other hand, aren't tangible. There are an extremely wide range of types of securities, but when it comes to REITs they are simply a claim to ownership of the company and any profits it earns. Investors don't have any claim of ownership of the assets the REIT owns.
The same goes for most other types of crowdfunded investments. Shares of a limited partnership or an LLC are also considered securities. So an investment in almost any other type of real estate fund is also considered a security.
1031 exchange into REIT
If you want to purchase shares of a publicly traded REIT with the proceeds from the sale of your business or rental property, a 1031 exchange isn't going to defer your capital gain. You'll be subject to capital gains and depreciation recapture tax. Depending on your current situation with the real estate asset you want to sell, it may be a very costly investment strategy to go from a real estate investment to a REIT investment.
However, this doesn't mean you're completely out of luck. You may still have some options available to receive the same tax benefit.
Umbrella partnership REIT (UPREIT)
With an UPREIT, the real estate is owned by an operating partnership (OP), with the REIT as the sole general partner owning a substantial share of the operating partnership units.
Investors are able to use an UPREIT to defer capital gains tax by contributing their property to the operating partnership in exchange for OP units. At this point, the investor doesn't own actual shares of the REIT; rather, it owns units in the partnership that actually owns the properties.
This tax-deferral process falls under IRC Section 721. Section 721 allows a real estate investor to trade their real estate for the operating partnership units, which typically hold the same value as the REIT shares. As long as the investor holds the OP units and the UPREIT continues to hold the property, the capital gains tax continues to be deferred.
The UPREIT transaction allows the property owner the opportunity to move into a passive investment and collect dividends from their shares. It also gives the investor the ability to convert their OP units to shares in the REIT when they're ready to cash out. Once their ownership is exchanged for shares, they can sell them on the market.
However, converting the OP units into shares triggers a taxable event. Once this happens, the investor will be required to pay all of their capital gains taxes from the original property as well as any capital gains from an increase in the value of their OP units.
Using a 1031 exchange and 721 exchange
REITs are selective with the properties they acquire. An investor will have a hard time finding a REIT that's interested in acquiring their small apartment building. Using a Section 721 exchange to trade real property for OP units is hard for anyone who doesn't own institutional-grade investment property.
Of course, there's still a way. The investor can do a 1031 and purchase an interest in real estate held by a REIT. The investor isn't buying shares of the REIT. They're buying fractional ownership as a tenant in common (TIC) in the property. The REIT and the investor become tenants in common.
The investor must hold their investment as a TIC for a sufficient amount of time, during which time they can receive dividends. Once they've held the investment for the required time, they can trade their interest as a TIC for partnership units in the REIT.
Other tax-deferral options
Delaware Statutory Trust (DST)
A Delaware Statutory Trust is a type of partnership where the investors actually own an undivided interest in the real property. The Internal Revenue Service (IRS) allows investors to use a 1031 exchange to defer their taxable gain when using the proceeds to invest in a DST property.
A 1031 into a DST investment follows the same process as a normal 1031 exchange. The seller still works with a qualified intermediary, and the time frames are the same. The difference in regulations comes in the way a Delaware Statutory Trust is structured and operated.
Deferred Sales Trust
A deferred sales trust is another option for selling your investment property and reinvesting the proceeds while deferring your capital gains tax.
A deferred sales trust transaction involves the investor selling the real estate to the trust. Instead of the trust paying cash for the property, the seller holds a note on the sale. The trust simultaneously sells the property to the buyer and holds the proceeds.
The investor isn't subject to capital gains tax because they haven't received payment for the real estate yet. The trust isn't taxed on its sale because it sold the property for the same price it just paid for it.
The term of the note can be whatever the seller wants it to be. Payments can be deferred until a certain point, or they can start receiving principal and interest payments on the note right away. Capital gains tax is only paid on the amount the seller receives from the note payments.
The seller is then able to use the trust to invest the sale proceeds into any type of investment they want, including REIT shares. The investment income can be left in the trust to grow or can be used to make principal and interest payments to the investor for the length of the note term, or until the investor is ready to cash out.
The bottom line
There are a lot of high-dividend REITs available that are attractive investments. An investment in a REIT provides the benefits of investment real estate while avoiding the headaches of managing the properties. It's no wonder real estate investors are interested in finding a way to do a 1031 exchange into REIT investments.
While the process isn't as simple as a normal 1031, the tax code does provide a way for investors to accomplish the same goal of deferring a taxable gain when moving into a passive real estate investment. If you're considering exchanging your investment property for REIT shares, or another type of passive real estate investment, it's important to discuss your options with a financial advisor and a CPA experienced in this type of investment strategy. If handled properly, these tax benefits can help you continue to grow your investments before it's time to pay the tax man.
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