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How to 1031 Exchange Into a REIT

October 25, 2023

Section 1031 of the Internal Revenue Code allows investors to exchange like-kind properties without paying immediate taxes on capital gains. The 1031 exchange is typically limited to direct property-to-property exchanges and does not apply to investments in Real Estate Investment Trusts (REITs).

The IRS does not consider REITs as like-kind property and so, it does not qualify for tax-deferred exchanges. This is because REIT is a financial security representing ownership in a portfolio of real estate assets and not a direct interest in real property.

But while REITs do not qualify for direct 1031 exchange, you can still leverage the tax-deferral benefits of 1031 exchange into a REIT using DSTs as a bridge. In this article, we’ll explore the possibility of 1031 exchanges into a REIT and what you need to know to stay compliant in the process.

Understanding the Basics

Understanding the Basics

A 1031 exchange is also known as a like-kind exchange. It’s a tax deferment strategy that allows investors to reinvest their proceeds from the sale of a relinquished property into another like-kind replacement property without attracting taxes on capital gains.

The U.S. mandates citizens to file all capital gain income from selling a property on their tax returns. However, with a 1031 exchange, you can defer capital gains taxes provided you reinvest the proceeds from the sale of your property into the purchase of a like-kind investment property.

The Internal Revenue Code and 1031 Exchanges

The Internal Revenue Code (IRC) constitutes rules and requirements that govern the 1031 exchange. According to Section 1031 of the IRC, properties that qualify for tax-deferred exchanges must:

  • Be real properties
  • Have a similar nature or character but may differ in grade or quality
  • Be held for investment, trade, or business purposes
  • Not be held primarily for sale
  • Not be intangible or personal property, such as inventory, notes, or other securities

What Is a REIT?

What Is a REIT?

A Real Estate Investment Trust (REIT) is a company that allows various investors to pool their funds into a diversified portfolio of income-generating real estate properties. Common examples of properties a REIT may invest in include office buildings, shopping malls, hotels and resorts, warehouses, etc.

REIT companies manage all real property assets in the portfolio. They collect and disburse all income generated from investments to investors. Since REIT investors are not direct owners of properties but stakeholders, REIT companies distribute its income as dividends to investors.

The Internal Revenue Code (IRC) sets the criteria that all REIT companies must meet to qualify as REITs. Such criteria imply that a REIT must:

  • Pay a dividend equivalent to a minimum of 90% of taxable income each year
  • Pay taxes as a corporation
  • Have fully transferable shares
  • Have a management body that constitutes a board of directors or trustees
  • Invest a minimum of 75% of its overall assets in cash and real estate
  • Derive a minimum of 75% of gross income from rents, mortgage interest, and other real-estate-related sources
  • Have a minimum of 100 shareholders after one year of existence

Benefits of Investing in a REIT

Benefits of Investing in a REIT

Portfolio Diversification

 By investing in REITs, you have access to a diversified portfolio of real estate assets, allowing you to spread risk across different property types and geographic regions. It’s more difficult to achieve this kind of diversification with direct real estate investments.

Professional Asset Management

From property acquisition to management and leasing, REITs manage investments through experienced professionals. So, you can leverage this expertise to minimize risks as you don’t need hands-on involvement in property management.

Regular Dividend Income

The U.S. law requires REITs to distribute at least 90% of their taxable income as dividends to shareholders, providing a consistent means of income for real estate investors.

Tax Efficiency

REITs are tax-advantaged investments because they are not subject to federal corporate income tax as long as they maintain the 90% minimum distribution. Their tax efficiency may result in higher dividend payouts.

Low Capital Investment

Unlike direct real estate investments, which often require substantial upfront investments, you can purchase shares of a REIT with less capital.

Investment Growth

REIT companies hold real estate assets that have the potential to grow in value and rental income. In response to the growth, REIT shares also appreciate simultaneously, thus increasing your capital value over time.

Types of REITs

Types of REITs

1. Equity REITs

These REITs own, manage, and generate revenue from real estate assets through rent and property appreciation. Such real estate assets may include office buildings, apartment complexes, shopping centers, etc.

2. Mortgage REITs

The mortgage REITs are commonly known as mREITs. They generate revenue through net interests from mortgages or mortgage securities associated with commercial or residential real property assets. In other words, mREITs provide real estate owners and operators with mortgages, loans, or mortgage-backed securities.

3. Hybrid REITs

These REITs combine the investment strategies of both equity REITs and mREITs. They generate revenue from real estate rental income as well as mortgages.

Tax Implications of REIT

Although a regular flow of dividends may sound attractive, REITs also have unique tax consequences. REIT dividend income may incur capital gains tax liabilities, ordinary income, or a return on capital. 

Capital gains tax rates are 0%, 15%, or 20% depending on the taxpayer’s income level. For instance, if you’re single and earn taxable income between $41,675 and $459,750, your capital gain tax rate will be 15%.

The majority of dividend income is considered ordinary income. Generally, the IRS does not consider REIT dividends qualified dividends, so these dividends do not qualify for reduced capital gains tax. Therefore, the dividend rates follow the investor’s marginal tax rate or tax bracket.

The Possibility of a 1031 Exchange Into a REIT

The Possibility of a 1031 Exchange Into a REIT

Because the IRS does not consider REITs as like-kind properties, directly purchasing REITs with the proceeds from the sale of a relinquished property does not qualify for tax deferral. But you can still enjoy the tax benefits via an indirect approach – DSTs to REITs. Here’s a rundown of the indirect approach.

The Indirect Route: DSTs to REITs

A Delaware Statutory Trust (DST) is a legal entity that holds title to a pool of real estate investments and then provides investors with undivided fractional ownership in the form of beneficial interests. DST investors have fractional shares of DST income and appreciation of the investments.

The IRS, under the Revenue Ruling 2004-86, provides that DSTs are eligible for a 1031 exchange. So, DSTs may serve as a bridge for 1031 exchange into REITs. The process involves two major phases. 

The first phase involves starting a 1031 exchange of relinquished property into a DST interest. Since DSTs are like-kind, you can purchase a DST interest after selling your relinquished property while postponing capital gains tax. After the purchase, you must hold DST interest until it matures before you liquidate the DST interest. 

In the second phase, you can transition your DST investment into an operating unit (OP) of a REIT through a 721 tax-deferred exchange, often known as UPREIT. This transition can happen in two ways:

  • Sell the DST portfolio to an existing REIT.
  • Create a new REIT using the real estate investments held in the DST.

DST investors can receive REIT’s partnership units in both ways, which they can directly exchange for REIT shares. With this approach, investors deferred capital gain taxes on properties.

Legal Hurdles and Considerations

“Like-Kind” Challenges

For a successful 1031 exchange, the exchange properties must be similar in nature or character. REITs are not like-kind, and the process it takes to convert investment property sales proceed into DSTs and then REITs, can be quite challenging.

Timing and Deadlines

The IRS is strict with the 1031 exchange timelines – 45 days for identification and 180 days for completing the exchange. The timing is even more critical for 1031 exchange into REITs as you must hold the DST for the appropriate waiting period before it can be absorbed into a REIT portfolio.

IRS Guidelines

To ensure a successful exchange, the IRC stipulates guidelines that investors must adhere to. For example, you can’t buy a replacement property, immediately convert it into DST interests, and then exchange it for REITs. A DST must stay for a stipulated waiting period before a REIT can absorb it into its portfolio, according to Section 721.

Financial Implications

Tax Implications

Exchanging a property into a REIT offers tax benefits through the combination of 1031 and 721 tax provisions. However, your dividend income from the REIT is still subject to taxes. These taxes include federal and state capital gain tax, depreciation recapture tax, and Medicare surtax. Also, any capital gains accrued from selling your REIT shares are subject to immediate taxes.

Risk Assessment

It may be challenging to sell fractional interests before a DST terminates due to its low liquidity and specific holding period. Also, real estate performance resulting from the national economy can affect DST returns, especially during a recession. If a DST eventually goes bankrupt, investors can lose their initial investment.

Return on Investment

ROI measures investment performance and profitability. For 1031 exchanges, the tax benefits positively influence their ROI. However, for REITs, the taxes imposed on dividend income affect investors’ ROI by minimizing their potential returns.

Real-World Examples and Case Studies

Let’s consider the case of Billie, a 1031 exchange client who wanted to sell her rental apartment and reinvest the proceeds in a REIT without attracting any capital gains taxes. In compliance with 1031 exchange rules, she exchanged her apartment for a DST interest, thus deferring tax on gains.

After three years of steady income flow from the DST, it matured, completed its cycle, and became a REIT. Billie DST’s interest got rolled over into the REIT operating partnership through a 721 exchange. Eventually, she successfully became an OP unit holder without generating immediate tax liabilities.

On the other hand, Sarah, another investor, owns OP units of a REIT and wanted to do the same transaction as Billie. During her 1031 exchange, she identified a seemingly attractive DST without thorough due diligence. Due to the DST’s poor management and underperformance, Sarah encountered limited liquidity. As a result, she couldn’t sell her fractional interest, and eventually, she lost her investment capital.

These case studies emphasize the need for proper research to understand the processes and regulations before engaging in a 1031 exchange into a REIT. Also, you can ensure compliance by involving qualified intermediaries throughout the exchange for a smooth experience.

Conclusion

1031 exchange into a REIT is a delicate process that requires expert knowledge and guidance. To guarantee a successful exchange, you must understand the IRS requirements to stay compliant, and be clear on the processes to enjoy the tax benefits. It’s recommended to work with real estate professionals and a qualified intermediary to facilitate your 1031 exchange and ensure compliance with IRS standards. Book a free consultation with our experts today at Unified Pacific 1031 Exchange to get started.

About The Author

Michael Bergman, CPA
Michael Bergman is a California licensed CPA and Real Estate Broker with over 32 years of experience in commercial real estate. Specializing in 1031 tax-deferred exchanges and financial oversight, his expertise is invaluable for complex real estate transactions. Michael’s unique blend of financial acumen and real estate knowledge positions him as a trusted advisor in the industry, offering sound advice and strategic insights for successful property management and investment.

Don’t let taxes hinder your property investment decisions. Connect with us today for a free, no-obligation 1031 exchange consultation. Let us help you navigate the process with ease.