Investing in real estate could be an excellent strategy for diversifying your portfolio. A real estate investment trust (REIT) and a 1031 exchange can be attractive options if you seek cash flow through real estate without management responsibilities. Some investors ask, “Can you do a 1031 exchange into a REIT?”
This guide will cover the basics of REITs, 1031 exchanges, and what investment options are available to you to successfully defer capital gains taxes through a multi-step process.
1031 Exchanges and REITs: The Basics
A 1031 exchange is a tax-deferral strategy under Section 1031 of the Internal Revenue Code that lets real estate investors sell an investment property and reinvest the proceeds into another like-kind property without paying capital gains tax. To qualify:
- The properties must be held for investment or business use.
- The investor must identify a replacement property within 45 days.
- The exchange must be completed within 180 days.
- A qualified intermediary (QI) must facilitate the transaction.
A real estate investment trust (REIT) is a company that operates, owns, and finances income-producing real estate. With a REIT, investors combine their funds to purchase assets, which are held in a portfolio. REIT investors do not directly own real estate but do own a share(s) in the REIT. A REIT company manages real estate properties, collects the rent, and distributes the money to shareholders via income dividends.
The Key Question: Can You 1031 Exchange Into a REIT?
So, can you 1031 exchange into a REIT? No, investors cannot directly perform a 1031 exchange into a REIT.
A REIT 1031 exchange is not possible because REIT shares are not considered “like-kind” property by the Internal Revenue Service (IRS) for the purposes of a 1031 exchange. However, there are alternative strategies for investors who want to maintain tax deferral and eventually gain exposure to a REIT.
UPREITs: A Potential Alternative
A common way for real estate investors to gain access to a Real Estate Investment Trust (REIT) while deferring capital gains taxes is through an UPREIT transaction, also known as a 721 exchange. In this structure, an investor contributes real property to a REIT’s Operating Partnership (OP) in exchange for Operating Partnership units. These OP units are typically convertible into REIT shares at a later time and allow the investor to continue deferring taxes under Section 721 of the Internal Revenue Code.
However, this type of transaction is often difficult to execute directly, as most REITs only accept institutional-grade real estate—not individual residential properties. Finding a REIT willing to accept direct contributions of real estate can be challenging.
Instead, many investors access the benefits of a 721 exchange indirectly, by first investing in a Delaware Statutory Trust (DST) that may later be contributed to a REIT by the sponsor.
Delaware Statutory Trusts (DSTs): A 1031 Exchange Option
DSTs are a popular vehicle for investors completing a 1031 exchange, as they qualify as like-kind replacement property under IRS rules. DSTs offer fractional ownership in institutional-quality real estate, giving investors access to professionally managed portfolios without the day-to-day responsibilities of property management. Investors don’t need to finance or close on the underlying real estate; instead, they receive beneficial interests in the trust and may earn passive income.
Some DST offerings include a built-in exit strategy: the potential for a future 721 exchange. In this scenario, the DST sponsor may eventually contribute the trust’s property to a REIT’s Operating Partnership, converting investors’ DST interests into OP units. This structure allows investors to continue deferring taxes through a 721 exchange, offering a longer-term alternative to traditional 1031 exchanges. However, it’s important to note that once a 721 exchange is completed, the investor cannot perform future 1031 exchanges, as OP units are considered personal property and no longer qualify as like-kind real estate.
UPREITs vs. 1031 Exchanges: Key Differences
While both UPREIT (721) and 1031 exchanges allow investors to defer capital gains taxes, they are fundamentally different in structure and flexibility. Here are two primary distinctions:
- Types of Assets Being Exchanged
In a 721 exchange, the investor contributes real estate to a REIT’s Operating Partnership in exchange for equity interest (OP units). In contrast, a 1031 exchange must involve the exchange of like-kind real estate. OP units are not considered real property, which is why a 721 exchange cannot be used to initiate another 1031 exchange later. - Timeline Requirements
A 1031 exchange comes with strict deadlines: 45 days to identify a replacement property and 180 days to close. A 721 tax exchange has no such timeline, as the transaction is based on contributing property to a partnership rather than executing a sale and purchase.
Choosing the Right Path: Investor Considerations
Before making an investment, consider the following factors:
- Investment Goals: Investor goals, e.g., income vs. appreciation and active vs. passive, will influence the choice between a 1031 exchange and alternative strategies.
- Investment Risks: Any investment carries risks, including illiquidity and market fluctuations. Assess whether these risks align with your financial goals and risk tolerance. Keep in mind that risks and rewards vary across different investments, so compare your options thoroughly.
- Management Preferences: Investors should consider their aptitude and desire for active vs. passive management.
- Legal and Tax Advice: It’s essential to consult with legal and tax professionals to ensure full compliance with all rules and to understand the tax implications of your investment.
Explore Your Options for Real Estate Investment
While you can’t directly do a 1031 exchange into a traditional REIT, UPREITs and DSTs offer different tax benefits. DSTs can also be used as replacement properties in a 1031 exchange.
It’s important to understand the options and align them with investor goals. Explore 1031 Crowdfunding’s resources for 1031 exchange and DST information. Register for an account to view available DST properties and learn more about your options.
This material does not constitute an offer to sell or a solicitation of an offer to buy any security. An offer can only be made by a prospectus that contains more complete information on risks, management fees and other expenses. This literature must be accompanied by, and read in conjunction with, a prospectus or private placement memorandum to fully understand the implications and risks of the offering of securities to which it relates. As with all investing, investing in private placements is speculative in nature and involves a degree of risk, including loss of your principal. Past performance is not necessarily indicative of future results and forward-looking statements and projections are not guaranteed to achieve the results described and your actual returns may vary significantly. Investments in private placements are illiquid in nature and there may be no secondary market or ability to sell the investment should the need for liquidity arise. This material should not be construed as tax advice and you should consult with your tax advisor as individual tax situations will vary. Securities offered through Capulent, LLC Member FINRA, SIPC
