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You can only perform 1031 exchanges with business properties or investment properties used for business.
What is a 1031 Exchange?
Typically, when you sell a property, you will have to pay taxes on its sale. If you plan on purchasing another property after selling the first property, you can instead use a 1031 exchange.
In a 1031 exchange, you can exchange one property for a replacement one. Because you aren’t selling and then buying a new property, you avoid capital gains tax.
1031s are named after IRC Section 1031, which made the process legal.
How to Do 1031 Into a REIT
While you cannot 1031 exchange into a REIT, there is a process you can use to exchange your property for shares in a REIT.
- Delaware Statutory Trust – Certain kinds of DSTs are considered legal “equal exchanges” for a 1031 exchange. You may invest your property into a DST without paying any taxes.
- Wait an appropriate length of time – After a hold period, a DST can enter a REIT as part of its business plan in an UPREIT exchange.
- Utilize Section 721 – Investors in the original DST qualify to exchange their ownership into equal-value shares of the REIT’s operating partnership (OP). These are called OP units.
Once the DST property has been folded into a REIT, investors have three options for using their OP units:
- Cash out: Investors can sell off their shares in the REIT. This will include significant tax consequences, as you must pay capital gains tax on all profits.
- Exchange for common stock: Investors may exchange their OP units at a 1:1 rate for common stock in the REIT. This will defer the taxable event, preventing immediate tax liabilities.
- Perform a partial exchange: Investors may exchange part of their OP units for common stock and cash out the rest. If this method is used, investors will have some taxes deferred, but not all.
You should fully understand a few definitions before attempting to 1031 into a REIT.
Delaware Statutory Trusts (DSTs)
A DST is a trust that uses laws in the state of Delaware to create a separate legal entity with one or more income-producing commercial property.
DSTs can have many different kinds of commercial properties, including:
- Retail spaces
- Office buildings
- Industrial real estate
There are several considerable drawbacks to having your property in a DST:
- Control: If you invest your property in a DST, you are not allowed direct control of it.
- Illiquidity: You cannot cash out on your property after you have invested it in a DST.
- Investor requirements: You must be accredited to invest in a DST.
In an UPREIT, a property owner may add their property to a REIT for partial ownership in the REIT.
Real estate investors can use this method to defer tax — as they are not gaining direct capital, they will not have to pay capital gains tax.
A taxable event is a transaction or action that will cause those involved to owe tax to the government, which can include:
- Receipt of a paycheck.
- Selling shares for a profit.
- Receiving dividends from stock.
- Using stock options.
Section 721 of the tax code allows investors with OP unit shares in a REIT to convert them into common shares.
An accredited investor is someone who is sanctioned to perform certain investments by the Security and Exchange Commission.
Accredited investors must have an income of at least $200,000 if filing individually or $300,000 if filing jointly and must also have a net worth above $1 million to apply.
Considerations and Disclosures
While there are many benefits to investing a REIT, instead of having a single property investment (e.g., cash flow, diversification and distributions), potential exchange investors should be wary of the process.
Always talk to a tax advisor or a real estate investment expert before attempting a multistep process to avoid capital gains tax.
DST to REIT transfer risks: After putting your real estate into a DST, you may have difficulty finding a REIT willing to accept your property, especially if it is worth less than $1 million.
Private REITs may not want to obtain your property, in which case the process will not work.
Time and effort: Turning a single property into shares of a REIT usually takes several years and can be a complicated process.
Before trying this, consider how much time and effort you are willing to put in and how much your time is worth.
While turning a single property into REIT shares using a 1031 exchange is possible, it may not be worth the headache to avoid the capital gains tax you will eventually pay on REIT dividends.
Deferral of tax: Taxes on the sale of commercial property can be significant, and it can be tempting to delay them for as long as possible.
Understanding that 1031s simply defer taxes — rather than avoid them — is essential.
If you exchange your property for REIT shares, you will have to pay the same taxes on shares sold, dividends gained and any other profits you make.
It is possible to use Section 1031 to exchange a property for shares in a REIT. You can do this by using a DST as an intermediary.
The process can take several years, and you may get stuck in a DST if you cannot find a REIT willing to take your property.
Investors should consider all potential drawbacks before committing to the process.
Here are answers to the most asked questions about 1031 exchanging into a REIT.
Can I 1031 into a real estate fund?
You can 1031 a single property into a real estate fund using a DST investment as an intermediary.
Can I 1031 exchange into a syndication?
You can 1031 into a syndication through a multistep process, similar to how you can 1031 into a REIT.
What is the difference between a REIT and a DST?
A REIT is a company that owns, operates or flips real estate properties for profit. A DST is a property account in Delaware set up to conduct business.
A DST itself is not a business, but a REIT is.