Unlock the Potential: 1031 Exchange Into a REIT and Seek Potential Rewards

While some real estate professionals argue that a 1031 exchange into a Real Estate Investment Trust (REIT) is not feasible due to the contrasting nature of real property assets and REIT shares, the truth is that with careful navigation, it can be accomplished. However, it requires following intricate procedures to ensure a seamless exchange.

Curious to learn more? Dive into the world of real property, 1031 exchanges, and REITs, and discover the path to exchanging your investment property for REIT ownership.

Distinguishing Between Real Property and Securities: Exploring 1031 Exchanges and REITs.

When it comes to investment property, the IRS classifies it as "real property," a tangible asset that can be exchanged for similar assets under Section 1031 of the Internal Revenue Code. This allows investors to defer capital gains taxes by reinvesting the proceeds into like-kind properties within a specific timeframe.

On the other hand, Real Estate Investment Trusts (REITs) operate differently. While they also deal with real estate properties, the investment structure revolves around investors purchasing shares in the REIT rather than owning the properties directly. REITs seek to generate cash through dividends, not rental income, which categorizes them as securities rather than real property.

It's important to note that a direct exchange from real property to a security is not permissible in a tax-deferred 1031 exchange since they are not considered like-kind assets.

Navigating the Path: Transitioning from Real Property to REIT Investment

If you aspire to transition from owning real property to becoming a REIT investor, you can achieve this by exchanging your real property assets for shares in a Delaware Statutory Trust (DST). Subsequently, you have the option to convert your DST shares into Operating Partnership (OP) units through an Umbrella Partnership Real Estate Investment Trust (UPREIT).


To reach your desired destination of REIT investment, consider the path of fractional ownership in a DST and its conversion into UPREIT OP units. Many REITs offer UPREITs as a means for DST investors to convert their interests into OP units within the UPREIT structure. By making this conversion into a partnership, you can still defer capital gains taxes, unless you choose to convert your UPREIT OP units into REIT shares.

This type of exchange comes with potential advantages and risks:

  1. Liquidity: Real property assets lack liquidity, but by exchanging your UPREIT OP units for REIT shares, you can access liquidity. However, keep in mind that this may trigger taxable events.
  2. Diversification: Instead of relying on a single property for cash flow, investing in UPREIT allows you to hold interest in a portfolio of assets with the potential for increased balance against economic volatility.
  3. Efficient estate planning: Passing down UPREIT OP units to heirs can provide a stepped-up basis, eliminating accumulated capital gains taxes (unless the units are converted into REIT shares).

It's crucial to note that once you complete the UPREIT process, you cannot execute a 1031 exchange to revert back to real property. Your investment must remain in the form of UPREIT OP units to continue deferring capital gains taxes.

Breaking It Down: Understanding the UPREIT Process

To better understand the UPREIT process, let's delve into how it works from both the perspective of the sponsor and the investor:

  1. Sponsor's Role:

The sponsor typically selects a high-quality asset, either from an existing REIT or through a new acquisition, and places it into a newly formed Delaware Statutory Trust (DST).

During the syndication period, the DST offers a predetermined amount of equity to investors, including those seeking 1031 exchanges. Investors acquire beneficial interests in the trust and have the potential to receive distributions similar to a standard DST investment.

2. Investor's Journey:

Investors become part of the DST by acquiring beneficial interests in the trust, enabling them to participate in the investment and receive the potential for regular distributions.

After a hold period of approximately two to three years, which satisfies the IRS safe-harbor guidelines for investment properties, the sponsor initiates a Section 721 UPREIT transaction for the property held under the trust.

As part of this transaction, investors have the opportunity to exchange their DST beneficial interests for operating partnership (OP) units in an entity owned by the REIT.

Following a predetermined lockout period, investors may have the option to redeem their OP units. They can choose to convert them into common stock in the REIT or receive cash, subject to the terms and conditions specified by the REIT.

Understanding the UPREIT process involves recognizing the roles of both the sponsor and the investors. The sponsor identifies and places a suitable asset into the DST, while investors participate by acquiring beneficial interests and later have the opportunity to exchange them for OP units. The ability to redeem OP units for common stock or cash becomes available after a lockout period, subject to the specific terms established by the REIT.

General Disclosure

Not an offer to buy, nor a solicitation to sell securities. All investing involves risk of loss of some or all principal invested. Past performance is not indicative of future results. Speak to your finance and/or tax professional prior to investing. Any information provided is for informational purposes only.

Securities offered through Emerson Equity LLC Member: FINRA/SIPC. Only available in states where Emerson Equity LLC is registered. Emerson Equity LLC is not affiliated with any other entities identified in this communication.

1031 Risk Disclosure:

·     There’s no guarantee any strategy will be successful or achieve investment objectives;

·     All real estate investments have the potential to lose value during the life of the investments;

·     The income stream and depreciation schedule for any investment property may affect the property owner’s income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities;

·     All financed real estate investments have potential for foreclosure;

·     These 1031 exchanges are offered through private placement offerings and are illiquid securities. There is no secondary market for these investments.

·     If a property unexpectedly loses tenants or sustains substantial damage, there is potential for suspension of cash flow distributions;

·     Costs associated with the transaction may impact investors’ returns and may outweigh the tax benefits

Alternative Real Estate Funds for Cash Investors

Real estate has long been considered a strategic investment – not only does it allow investors to potentially earn income, leverage debt to build equity, strive to build wealth, and potentially hedge against inflation, but it also can offer various tax breaks.

However, real estate investing is not for everyone. It generally requires a large capital investment to get started and is limited to those who are ready to engage in active management.

Those looking to access the potential benefits of real estate investing, seek to earn income, and diversify their portfolios, all while investing in passive real estate investment opportunities, can consider turning to alternative funds. In this article, we explore alternative real estate investment funds available for today’s cash investors and review examples of funds offered historically by Perch Wealth.

Alternative Investments: Funds, Syndications, and DSTs

One alternative is to invest in a commercial real estate syndicate or fund. However, investments in funds, syndications and DSTs are typically illiquid. This can have an investor's capital tied up from three to seven years or longer, depending on the anticipated business plan and hold period. Those looking to preserve more liquidity opportunities have a few other options if interested in adding real estate to their portfolios.

Delaware Statutory Trusts (DSTs)

Delaware Statutory Trusts allow accredited investors to co-invest in institutional-quality real estate alongside many others. This lowers the barrier to entry and allows for indirect ownership (the IRS still treats it as direct ownership for tax purposes), while the property is otherwise managed and overseen by an experienced third-party sponsor.

Real Estate Investment Trusts

A REIT, which stands for "real estate investment trust," is a corporation that owns and/or manages income-producing commercial real estate. There are many types of REITs. Most will focus on a specific product type (e.g., retail, hospitality, multifamily housing, senior living facilities, student housing, office, self-storage, industrial and the like) or geography (e.g., commercial real estate in the Northeast vs. Southwest).

When an individual buys a REIT share, they are purchasing a share of the company that owns and manages the rental property. Shares of publicly traded REITs can be purchased and sold as easily as other stocks, even on a daily basis, thereby providing significant liquidity to investors.

REITs typically have well-defined investment parameters. They then invest in real estate that meets those parameters. By law, REITs are required to return 90% of profits to investors in the form of dividends.

Interval Funds

An interval fund is a type of closed-end fund that offers liquidity to investors at stated intervals - typically quarterly, semi-annually or annually. This means investors can sell a portion of their shares at regular intervals at a price based on the fund's net asset value. However, there is no guarantee that investors can redeem their shares during a given redemption period. As such, interval funds should generally be treated as long-term investments but in turn, will usually seek to offer an illiquidity premium in exchange.

Interval funds can be used to invest in many securities and asset classes, including but not limited to real estate. A single interval fund is not limited to investing in a single asset class; in fact, they can invest in various assets as a means of diversifying their holdings.


Other Income Funds

There are dozens, if not hundreds or thousands, of different types of investment funds. These include equity funds, bond funds, money market funds, mutual funds, and hedge funds. Many investors have started investing in real estate through one of these types of funds.

A real estate income fund is a specific subset of funds that is focused exclusively on investing in income-generating real estate. Real estate income funds provide another entry point for those looking to invest cash in large commercial real estate portfolios. Real estate income funds are particularly appealing to retail investors who want to own institutional-quality real estate that would otherwise be out of reach to them.

A real estate income fund pools capital from many investors, and then the fund's sponsor oversees all of the fund's activities - from due diligence and underwriting, to property renovations, stabilization, ongoing management and eventually, disposition. Depending on the nature of a real estate income fund, the fund can have different investment minimums as well as lengthy hold periods and therefore, the capital invested should be considered illiquid during that hold period.

Are you ready to consider investment options that seek to provide greater, more predictable returns on your investments? If so, it might be time to consider investing in a high-yield real estate fund. Contact us today. We are happy to discuss available options with you to determine which combination of investments would be best for you based upon your specific investment objectives.

General Disclosure

Not an offer to buy, nor a solicitation to sell securities. Information herein is provided for information purposes only and should not be relied upon to make an investment decision. All investing involves risk of loss of some, or all principal invested. Past performance is not indicative of future results. Speak to your finance and/or tax professional prior to investing.

Securities offered through Emerson Equity LLC Member: FINRA/SIPC. Only available in states where Emerson Equity LLC is registered. Emerson Equity LLC is not affiliated with any other entities identified in this communication.

1031 Risk Disclosure:

The Importance of a QI in Your 1031 Exchange

A qualified intermediary (QI) is required for all 1031 exchanges. Given the importance of the QI in an exchange, it is imperative for real estate investors to identify one they can trust and rely on. Achieving this, however, can be difficult – how does an investor know whether a particular QI is credible? Here is a brief tutorial on how to select a reputable QI for a 1031 exchange.

What is a QI?

A QI, also known as an accommodator, is an individual or entity that facilitates a 1031, or like-kind, exchange as outlined in Internal Revenue Code (IRC) Section 1031. The role of a QI is defined in the Federal Code as follows:

A qualified intermediary is a person who -

(A) Is not the taxpayer or a disqualified person, and

(B) Enters into a written agreement with the taxpayer (the “exchange agreement”) and, as required by the exchange agreement, acquires the relinquished property from the taxpayer, transfers the relinquished property, acquires the replacement property, and transfers the replacement property to the taxpayer. (26 CFR § 1.1031(k)-1)

An individual does not need to meet any eligibility requirements or acquire a license or certificate to become a QI. However, the Internal Revenue Service (IRS) does stipulate that anyone who is related to the exchanger or has had a financial relationship with the exchanger – such as an employee, an attorney, an accountant, an investment banker or broker, or a real estate agent or broker – within the two years prior to the sale of the relinquished property is disqualified from acting as the exchanger’s QI.

Why is having a QI important in a 1031 Exchange?

Every 1031 exchanger must identify a QI and enter into a written contract prior to closing on the relinquished property. Once selected, the QI has three primary responsibilities: prepare exchange documents, exchange the properties, and hold and release the exchange funds.

Preparing Exchange Documents

Throughout the exchange, the QI prepares and maintains all relevant documentation, including escrow instructions for all parties involved in the transaction.


Exchanging Properties

A 1031 exchange requires the QI to acquire the relinquished property from the exchanger, transfer the relinquished property to the buyer, acquire the replacement property from the seller, and transfer the replacement property to the exchanger. Although the QI also transfers the title, the QI does not actually have to be part of the title chain. 

Holding and Releasing Exchange Funds

For an exchanger to defer capital gains, all proceeds from the sale of the relinquished property must be held with the QI; any proceeds held by the exchanger are taxable. Therefore, the QI must take control of the proceeds from the sale of the relinquished property and place them in a separate account, where they are held until the purchase of the replacement property.

Exchangers must meet two key deadlines for the exchange to be valid. The first comes at the end of the identification period. Within 45 calendar days of the transfer of the relinquished property, the exchanger must identify the replacement property to be acquired. The second comes at the end of the exchange period. The exchanger must receive the replacement property within 180 calendar days of the transfer of the relinquished property. These deadlines are strict and cannot be extended even if the 45th or 180th day falls on a Saturday, Sunday, or legal holiday.

What should investors consider when choosing a QI?

Since a QI is not required to have a license, investors should conduct due diligence to ensure they select an individual who can properly manage the 1031 exchange. Unfortunately, the IRS does not excuse any errors committed by a QI, and, as a result, investors may be required to pay taxes on the exchange due to these mistakes. Here are a few things investors should consider when selecting a QI.

State Regulations

While the federal government does not regulate QIs, some states have enacted legislation that does. For example, California, Colorado, Connecticut, Idaho, Maine, Nevada, Oregon, Virginia, and Washington have all passed laws overseeing the industry. Many of these states have requirements for licensing and registration, separate escrow accounts, fidelity or surety bond amounts, and error-and-omission insurance policy amounts.

Federation of Exchange Accommodators

The Federation of Exchange Accommodators (FEA) is a national trade association that represents professionals who conduct like-kind exchanges under IRC Section1031. The FEA’s mission is to support, preserve, and advance 1031 exchanges and the QI industry. Association members are required to abide by the FEA’s Code of Ethics and Conduct.

In addition, the FEA offers a program that confers the designation of Certified Exchange Specialist® (CES) upon individuals who meet specific work-experience criteria and pass an examination on 1031 exchange laws and procedures. Holders of this certificate must pass the CES exam and meet continuing education requirements. The “designation demonstrates to taxpayers considering a 1031 exchange that the professional they have chosen possesses a certain level of experience and knowledge.”

Knowledge and Experience

As mentioned, a QI’s mistake in a 1031 exchange can result in a taxable transaction. Investors who are in the process of selecting an accommodator should review each individual’s qualifications – including knowledge and experience in the industry – before making a final decision. Investors should inquire whether the individual is full- or part-time; how many transactions and how much in value the individual has facilitated. Additionally, it is important to know whether the individual has any failed transactions and, if so, why.

Knowledge about 1031 exchanges is critical. Not only should potential QIs know the basics, but they should understand the ins and outs of the 1031 exchange process. For example, QIs should know what qualifies as a like-kind property. Likewise, they should know about Delaware Statutory Trusts (DSTs), one of the most commonly overlooked alternative 1031 exchange solutions. Unfortunately, many QIs are not familiar with DSTs. Finding a knowledgeable and experienced QI is crucial for investors who want to successfully defer capital gains while continuing to meet their overall financial objectives.


How should an investor go about selecting a QI?

To find a QI in good standing, investors should seek referrals. Word of mouth can be a great way to find a credible QI. Investors can ask for a referral from a certified public accountant (CPA) with 1031 exchange experience, a real estate attorney, a reputable title company, or even the other party in the exchange.

When vetting a potential QI, investors need to ask questions that will reveal the individual’s depth of knowledge and experience – beyond just the basics. For instance, the FAE requires potential QIs to work full-time for at least three years before they can even sit for the CES exam. Three years is a good baseline to start from when judging a QI’s experience; five to 10 years is a solid amount.

Finding a QI is one of the most critical parts of a 1031 exchange, as the transaction cannot be completed without one. Investors must ensure that their QI is experienced and thoroughly understands the various tax codes involved. Investors also need to ensure that the QI has not been financially connected to them within the past two years and is not a relative, employee, or agent. The IRS does not take these factors lightly; failure to comply with what is presented here may lead to hefty penalty fees – or the IRS may prohibit the exchange from occurring altogether.

General Disclosure

Not an offer to buy, nor a solicitation to sell securities. Information herein is provided for information purposes only, and should not be relied upon to make an investment decision. All investing involves risk of loss of some or all principal invested. Past performance is not indicative of future results. Speak to your finance and/or tax professional prior to investing.

Securities offered through Emerson Equity LLC Member: FINRA/SIPC. Only available in states where Emerson Equity LLC is registered. Emerson Equity LLC is not affiliated with any other entities identified in this communication.

1031 Risk Disclosure: