Some 1031 exchange investors have questioned if selling their investment real estate properties and completing a 1031 exchange into a Real Estate Investment Trust is possible (REIT). Yes, in a nutshell, investors must adhere to a number of intricate stages in order to effectively execute the trade.
Since owning real estate assets is distinct from owning shares of a REIT, some real estate experts may claim that a 1031 exchange into a REIT is not conceivable. Although rather difficult, it is feasible to exchange your real estate investment for ownership in a REIT.
Continue reading to find out how it’s done, but first, let’s define real estate, 1031 exchanges, and REITs.
What is a Real Estate Investment Trust?
A corporation that funds, owns, or manages real estate that generates revenue is known as a real estate investment trust, or REIT. Real estate investors combine their money to buy real estate properties through a REIT. You won’t own real estate if you decide to invest in REITs. Instead, you will be the owner of one or more REIT shares.
Dividends from the revenue generated by the real estate assets are paid to investors as income. High-end real estate holdings are managed by a REIT firm, which also receives the rent and pays income dividends to shareholders.
There are several sorts of REITs, and each form of REIT invests in a particular class of assets. Private-placement REITs and public REITs are the two main varieties of REITs.
REITs with private placement
Private REITs are not listed on any stock exchanges and are not required to register with the Securities and Exchange Commission. A stake in a private-placement REIT is often exclusively accessible to accredited institutional investors, unlike a publicly traded REIT. Private REITs are less liquid investments than public REITs since they are not publicly traded.
Compared to real estate assets, REITs are easier to invest in because many of them are publicly listed. Being readily tradable like stocks, publicly listed REITs have the benefit of being liquid assets.
Additionally, some publicly traded REITs are not traded on any federal stock market. The SEC must receive these REITs’ registrations. They are harder to purchase and sell via an exchange. Due to the fact that shareholders may only sell their shares through a buyback strategy or a secondary market, public non-listed REIT shares have restricted liquidity.
Investors do not have legal title to the assets in REITs, whether they are private or public. Investors in REITs hold securities rather than real estate.
What is a 1031 Exchange?
An investor can postpone capital gains taxes on the successful disposal of an investment property (the Relinquished Property) if they “exchange” the property for another (the Replacement Property) that is regarded as being of “like kind.” A 1031 Exchange, also known as a like-kind exchange, is a specific type of real estate transaction. The Internal Revenue Tax Code’s provision that authorizes the transaction bears the same name, and it lays out a number of requirements that a taxpayer must follow while engaging in one. There are two principles that are particularly pertinent to the context of this essay.
To begin, the replacement property must be “of the same sort” as the surrendered property. According to IRS regulations, a property is defined as being “of the same origins or character” The majority of real estate is regarded as being “like kind” to other real estate regardless of the property’s condition or class as long as both properties are kept “for productive use in a trade or for business or investment” and are both situated in the United States. An office building is similar to an apartment building, for instance, while a retail mall is similar to a warehouse.
The replacement property must be found by real estate investors within 45 days following the sale of the property that was given up, and the sale must be finished within 180 days. Simply having a short amount of time to find a substitute residence might be stressful. The transaction can become taxable if one cannot be located in time.
Can You Perform a 1031 Exchange into a REIT?
Can a REIT be 1031-ed into? You will not be eligible for a 1031 exchange if you want to use the money from the sale of your rental or commercial property to purchase shares of publicly listed REITs. Both capital gains tax and depreciation recapture tax will apply to you.
Making the switch from direct ownership to a REIT investment may be an expensive investment option, depending on the circumstances of the real estate property you want to sell. Thankfully, you might have more alternatives to obtain this tax benefit.
Using a REIT
A REIT is picky about the real estate assets it buys. For instance, it can be challenging to locate a REIT willing to purchase your modest apartment complex. While it is not feasible to directly convert 1031 into a REIT, you might be able to perform a 1031 exchange and purchase a real estate asset that a REIT owns.
Using an UPREIT
Umbrella Partnership Real Estate Investment Trust, or UPREIT, is a different option for investors wanting to convert the profits from the sale of real estate into a REIT.
The real estate holdings in a UPREIT are held by an “Operating Partnership,” of which the REIT is the general partner and holds a majority stake (OP Units). Investors can transfer their assets to the operational partnership in return for Operating Partnership Units to postpone capital gains. When the transaction is complete, the investor acquires shares in the Operating Partnership, which owns the properties, not shares of the REIT.
Exchange Rules under Section 721
This sort of transaction is permitted by IRC Section 721, which stipulates that “…no gain or loss shall be recognized by a partnership or any of its partners in the case of a contributing property to the partnership in return for an interest in the partnership.” Capital gains taxes are postponed forever as long as the UPREIT has the property and the investor keeps the Operating Partnership Units.
Should You Exchange into a UPREIT?
The UPREIT approach’s main advantages for investors are speed and simplicity. Finding a “replacement” asset in a 1031 Exchange is easier and more productive when a property is contributing to an operational partnership. Furthermore, this is a passive investment that allows investors to receive dividends on their partnership shares.
REITs are picky, though. Not every property will be allowed into the UPREIT. Usually, they seek out substantial assets of the institutional caliber that will be advantageous to the partnership. Unfortunately, the majority of private investors do not own any of these kinds of properties. Therefore, even while the transaction may be simpler from a procedural standpoint, it could be trickier to actually incorporate the asset into the partnership. Thankfully, there are other options.
What can be an alternative to UPREITs?
Tenants in Common (TIC) properties and Delaware Statutory Trusts are the two most popular alternatives for investors looking for replacement properties that aren’t UPREITs (DST).
A person can sell their home and use the money to buy a small portion of an asset of institutional grade in a Tenants In Common institutional ownership. The property’s “Tenants In Common” title makes this possible. The IRS has established a set of guidelines that must be followed by the group in order for the investor who acquires a piece of the property to be eligible for a complete tax deferral.
An investor can sell their home and use the profits to buy a Delaware Statutory Trust, a specialized kind of trust that owns and manages institutional-caliber commercial real estate assets. A DST Investment or DST Property may be utilized as a substitute in a 1031 Exchange under IRS Revenue Ruling 2004-86. Many significant real estate companies have DST investing options, which are easily found with a quick online search.
One of these alternatives could be a better fit for a real estate developer than an UPREIT, depending on their individual goals, return expectations, tolerance for risk, and time horizon.
An investor can postpone their need to pay taxes on a taxable gain on the purchase of an investment property by engaging in a 1031 Exchange, a particular kind of real estate transaction. Finding an appropriate replacement property within that specified time limit is one of the difficulties in a 1031 Exchange, despite the fact that they can offer significant tax savings.
NNN Deal Finder can provide you with further guidance if you’re still not sure if DSTs are the correct choice for you.
For your 1031 exchange, NNN Deal Finder provides a comprehensive solution. Our seasoned team of securities and real estate experts has built an online marketplace of thoroughly verified real estate products. We provide our clients with creative solutions so they may invest with confidence.
Call us at 00-240-9094 today to generate passive income from real estate and increase your ROI.