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:
- 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.
- 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.
- 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:
- 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.
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