REITs offer advantages for those seeking liquidity and diversification, but aren’t treated the same as other real property investments when it comes to taxation.
Because of our team’s vast experience in performing Section 1031 like-kind exchanges, we at JTC get a lot of questions about Section 1031. In this series, we’ll attempt to answer some common questions to help prospective exchangers better understand complex 1031 scenarios.
Today’s question:
Is it possible to do a 1031 exchange with a REIT as my replacement property?
While this may seem like a simple yes-or-no question, the real answer is a bit more nuanced. To understand it, we need to first discuss REITs and how they are treated in the tax code.
What is a REIT?
A Real Estate Investment Trust (REIT) is an investment vehicle that allows individuals to invest in a portfolio of income-producing real estate. From the U.S. Securities and Exchange Commission:
A REIT is a company that owns and typically operates income-producing real estate or related assets. These may include office buildings, shopping malls, apartments, hotels, resorts, self-storage facilities, warehouses, and mortgages or loans. Unlike other real estate companies, a REIT does not develop real estate properties to resell them. Instead, a REIT buys and develops properties primarily to operate them as part of its own investment portfolio.
Some REITs are SEC-registered and publicly traded just like stocks or other securities, while others are not exchange-traded. Investors can purchase shares of specific REITs or invest in REIT mutual funds and ETFs. It has been estimated that REITs hold as much as $4.5 trillion in real estate worldwide.
REITs are typically not taxed at an entity level, allowing investors to avoid double taxation on their dividends, which are generally treated as ordinary income. REITs must invest in real assets, and must derive the majority of their income from real estate activities. REITs must also pay at least 90% of their annual taxable income in dividends.
This steady dividend income is one of the major reasons people invest in REITs. Investors also benefit from the appreciation of the properties in the REIT’s portfolio, and can realize these gains upon selling their shares. According to Forbes, “Residential properties generate an average annual return of 10.6%, while commercial properties average 9.5% and REITs 11.8%.”
Another reason people invest in REITs is that they provide access to large commercial properties that may be out of reach for average investors. REITs also offer diversification, as the largest REITs can own thousands of properties. It’s possible to find a REIT focused on a specific sector like residential, office, industrial, or retail.
Publicly-traded REITs offer the advantage of liquidity, since individual investors can sell their shares at any time. Privately-traded REITs don’t offer this liquidity, but may offer higher dividends. REIT shares are eligible for a step-up in basis upon death, just like real property investments.
Can I perform a 1031 exchange into a REIT?
Property owners looking for steady income, diversification, and less-active property investments as they enter retirement may be interested in transitioning from a whole property to a REIT. Unfortunately, this transition can’t be made through a 1031 exchange.
While a REIT may own real property, the entity itself is not considered real property under Section 1031, and is therefore not eligible to be used as replacement property in a 1031 exchange. But if you’re interested in a professionally-managed, diverse portfolio of income-producing properties, there is another type of real estate investment you may want to consider.
1031 exchange into a Delaware Statutory Trust
Like a REIT, a Delaware Statutory Trust (DST) is a passive investment that allows individuals to access institutional-quality real estate. In a DST, up to 499 investors pool their money to invest in either a single property or multiple properties, which are managed by a professional property manager. Also like a REIT, investors receive distributions from the income generated by these properties.
Unlike a REIT, a DST is not a “blind pool.” DST investors know which properties are being purchased by the DST, and can choose a specific DST based on the properties involved. DSTs are also generally smaller, as there are limits to the number of investors they can have.
The most important difference for our discussion is that a DST interest is considered real property under Section 1031. In 2004, the IRS released Revenue Ruling 2004-86, which allows the use of a DST to acquire real estate where the beneficial interests in the trust will be treated as direct interests in replacement property for purposes of IRC §1031. That means you can exchange from a whole property into a DST (or many DSTs) and vice-versa.
DSTs offer many of the advantages of REITs: diversification, passivity, access to high-quality commercial properties, stability during periods of inflation, and steady income. One thing they lack is liquidity: an interest in a DST is transferrable, but because they are not publicly traded, it’s not always simple to find a buyer. While both DST and REIT investments can qualify for a step-up in basis, the DST does not allow for an immediate exit, while a REIT offers that flexibility.
There are pros and cons of both DSTs and REITs, and many reasons why an investor may prefer one over the other. But if you’re looking to perform a 1031 exchange, a DST is an option for a replacement property, while a REIT is not. Though you may not be able to exchange into a REIT right now, investors eyeing a REIT as their endgame do have a method for getting there.
Section 721 exchange from a DST to a REIT
Section 721 of the tax code, like Section 1031, deals with nonrecognition of gains. While Section 1031 covers real property sales, Section 721 allows for tax deferral when property is contributed to a partnership in exchange for an interest in the operating partnership, which is commonly referred to as an upREIT or Umbrella Partnership Real Estate Investment Trust.
If property (in this case real estate) is contributed to an operating partnership and the contributing party receives an ownership interest in the partnership in exchange, tax deferral is possible through Section 721. This makes it possible to go from a 1031 property to a REIT, using a DST as the middle step.
Imagine you own a residential rental property that you’ve been managing for many years, and you want to diversify and transition to a less-active investment. You perform a 1031 exchange into a Delaware Statutory Trust. This DST includes, as part of its business plan, the potential to be acquired by an affiliated REIT.
When the REIT buys out the DST, you are given the option to exchange your DST ownership for units of the REIT’s Operating Partnership (“OP”), which are then converted into the REIT’s common stock through what is known as a 721 Umbrella Partnership Real Estate Investment Trust (UPREIT) exchange.
The downside of this is that once your investment has been converted into REIT OP units, you will no longer be able to perform future 1031 exchanges, as OP units and REIT shares do not qualify as real property. When you sell your REIT shares, they will be subject to taxation.
Conversely, a DST allows you to keep your options open, as you can exchange back to a whole property or into another DST, and down the road, you could choose a DST that is set to be acquired by a REIT. That’s why a DST is a solid option for those who want the benefits of a REIT but aren’t ready to forego the option of future exchanges.
As a Qualified Intermediary, JTC works with investors to perform 1031 exchanges involving many different property types and ownership structures. We help facilitate exchanges both into and out of DSTs, and unlike many QIs, we have specific expertise in the nuances of these types of exchanges. If you’re considering a 1031 exchange into a DST, work with a QI that has the experience and capabilities to help you succeed.
To learn more about JTC’s 1031 exchange services,
