Wondering if you can sell your investment property and invest in a Real Estate Investment Trust (REIT) through a 1031 exchange? The answer is yes, but the process is complex and requires specific steps. Some real estate experts may argue that it's not possible as the nature of real property and REIT investments are different.
However, with a bit of planning and understanding of 1031 exchanges and REITs, it is possible to make the transition. Learn how to navigate the complex path and make your investment property to REIT transition a success.
When you sell an investment property, you're disposing of a physical asset that the IRS classifies as "real property." The Internal Revenue Code Section 1031 allows investors to exchange these properties for similar assets, or “like kind”, held for investment or business purposes. This can be done to defer capital gains taxes, as long as the proceeds from the sale of the original property are reinvested in one or more similar properties within a specific time frame. This process is commonly known as a 1031 exchange.
A Real Estate Investment Trust (REIT) operates in a different way, however. REITs invest in real estate properties and hold them in a portfolio. Instead of buying the properties themselves, investors buy shares in the REIT. The cash flow generated by REITs comes from dividends, rather than rental income.
Since REITs are considered securities, they cannot be considered "like-kind" assets under the 1031 exchange regulations. That's why it's not possible to directly exchange your investment property for REIT shares. However, there are still ways to complete a 1031 exchange into a REIT, but they require a bit more planning and complexity.
Explore the Option of Transitioning from Property Ownership to REIT Investment through a Delaware Statutory Trust (DST) and UPREIT Conversion.
If you're considering investing in a REIT, one way to do it is through fractional ownership of a DST and subsequent conversion into an Umbrella Partnership Real Estate Investment Trust (UPREIT). Many REITs offer this option, where DST investors can convert their interests into Operating Partnership (OP) units. This conversion is done through a partnership which enables you to defer capital gains taxes, unless you decide to convert your UPREIT OP units into REIT shares later on.
It's important to consider that this type of exchange may have advantages and drawbacks. Potential benefits could include:
● Offers liquidity opportunities by allowing conversion of UPREIT OP units into REIT shares, albeit with a taxable event
● Provides diversification options to help balance out economic volatility by creating a portfolio of assets
● Facilitates efficient estate planning by potentially enabling transfer of UPREIT OP units to heirs with potential elimination of capital gains taxes(unless converted to REIT shares)
An important aspect to keep in mind when considering UPREIT conversion is that it marks the end of the 1031 exchange process. It's not possible to exchange UPREIT OP units back into real property, In order to maintain the deferral of capital gains taxes, your investment must remain in the form of UPREIT OP units.
Here's a step-by-step breakdown of the UPREIT process from the perspectives of both the sponsor and the investor:
● The sponsor typically places an institutional-grade asset, whether from a REIT or a new acquisition, into a newly formed Delaware Statutory Trust (DST).
● During the syndication period, the DST offers 1031 exchange and other investors a predetermined amount of equity. Investors acquire beneficial interests in the trust and begin earning distributions similar to a standard DST investment.
● After a hold period of typically two to three years, which satisfies the IRS safe-harbor guidelines for investment properties, the sponsor executes a Section 721 UPREIT on the property held under trust.
● Investors then exchange their DST beneficial interests for operating partnership (OP) units in an entity that's owned by the REIT.
● After a predetermined lockout period, investors have the option to redeem their OP units for common stock in the REIT or for cash, subject to the terms laid out by the REIT.
Exit strategies can be challenging for real property and DST investors. The UPREIT structure provides an opportunity to achieve greater liquidity and diversification of portfolio, but the process can be lengthy and complicated. Additionally, the loss of the ability to defer capital gains tax liabilities through 1031 exchanges may not be worth it for some investors. It's recommended to seek guidance from an expert with knowledge of DSTs, UPREITs and REITs before making a decision to divest real property assets for shares in a REIT.
During syndication, DST provides 1031 exchange investors and others with a set amount of equity. They obtain a beneficial interest in the trust and begin receiving distributions similar to other DST investments. After a few years, the sponsor executes a Section 721 UPREIT on the property, and the investors exchange their DST beneficial interests for OP units owned by the REIT.
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