Do REITs Qualify for 1031 Exchanges??
REIT shares do not qualify for 1031 exchanges as the IRS considers them personal property, which is not like kind under IRC Section 1031 (only like kind property qualifies for 1031 exchange). However, investors can still relinquish their property and invest in a REIT by combining the 721 and 1031 exchanges in a process called an UPREIT.
This is one of the most common questions when talking with investors looking for a passive income stream when approaching retirement. You have arrived at the point where managing your property has become a chore. It is no longer a weekend hobby, and one thought that comes to mind is “I wonder if I could trade this property for shares in a REIT?” Unfortunately, the short answer is “not likely.” Unless a REIT is knocking at your door and offering to buy your property, there is no other direct way of making an exchange for liquid shares. Most REITs acquire larger portfolios of property ($250MM+) and are typically not interested in looking at single-property acquisitions.
However, there are ways that an investor can target passive income with a potential REIT exit.
Before we dive into how you can access a 721 REIT exchange, we must understand the basic advantages that a REIT offers. A Real Estate Investment Trust is a portfolio of properties that, among other restrictions, is required to pay 90% of its taxable income as dividends to shareholders, and 75% of the gross income must come from real estate holdings. The size of a REIT can vary from hundreds of millions to billions of dollars of assets under management. Many of them are traded on major stock exchanges, and there are also non-traded public REITs and private REITs. Some of the advantages of investing in a REIT include diversification, professional management, published financial records, and liquidity (this last advantage is especially true with publicly traded REITs).
In 2004, the IRS provided Revenue Ruling 2004-86, which defined the Delaware Statutory Trust structure (commonly known as a DST) as a like-kind investment for a 1031 exchange. This structure opens the possibility for an investor’s selling one property to exchange into a DST. And although this would become a two-step transaction, it is potentially the best way to achieve a REIT exit. The first step of this transaction would give an investor title to the real estate through a beneficial interest in the trust, qualifying as a regular 1031 exchange.
Some sponsors in the industry have been forming DST portfolios with a strategically planned sale to a REIT, which would benefit from the purchase of an aggregation of portfolios that meet their acquisition requirements. By diversifying an exchange into multiple DST offerings, an investor is now one step closer to owning shares in a REIT. The second step of this transaction would occur at the liquidation of the DST investments and the sponsor’s successful completion of a 721 exchange, also known as an UPREIT. This second step can be achieved through either the sale of a portfolio to an existing REIT or the formation of a new REIT through the aggregation of the portfolios managed by the sponsor. Regardless of the intended exit strategy, the investor at this point can receive operating partnership units, which are then directly exchanged for shares in the REIT.
If the deal is structured correctly, investors can effectively defer their capital gains from an individual property to a DST—and ultimately to a REIT. This is the end of the tax deferral in the 1031 cycle, and it is important to note that once the shares of the REIT are sold, this would trigger a taxable event for the investors. One of the advantages at this stage is that investors have liquid shares and can then plan the disposition of shares, and payment of capital gains, in multiple tax years (very useful for estate planning purposes).
Although eventually exchanging into a REIT is possible, investors must plan in advance to make this switch. There are risks and benefits associated with each investment, and each step of this transaction needs to be carefully evaluated. Investors should read the memorandum or prospectus and consult with tax and legal advisors regarding their specific situation.