Can You 1031 Exchange Into a REIT?
Investing in real estate can be an excellent strategy for diversifying your portfolio. A REIT can be an ideal investment option if you want cash flow via real estate without worrying about management responsibilities. So, can you do a 1031 exchange into a REIT? While using a 1031 exchange to invest in REIT shares may sound like a wise idea, doing so can be complicated and may not be directly possible.
This guide includes the basics of REITs, how 1031 exchanges work and what investment options are available to you.
What Is a REIT?
A real estate investment trust, also referred to as a REIT, is a company that finances, owns or operates income-producing real estate. With a REIT, investors pool their funds to purchase assets. If you become a REIT investor, you will not be a real estate owner. Instead, you will own a share or shares in the REIT.
Investors receive income in the form of dividends collected from the money the real estate properties generate. A REIT company manages high-valued real estate properties, collects the rent and distributes the money to shareholders via income dividends.
There are various kinds of REITs, and the different REITs invest in specific asset types. The primary types of REITs are private-placement REITs and public REITs.
Private REITs are exempt from registration with the Securities and Exchange Commission and are not on any stock exchange. Unlike a publicly traded REIT, a share in a private-placement REIT is usually available only to accredited institutional investors. Because a private REIT is not publicly traded, it is not a highly liquid investment like a public REIT.
Many REITs are publicly traded, making them easier to invest in than real estate assets. Publicly traded REITs offer the advantage of being liquid investments, as people can buy and sell them like stocks.
Some public REITs are also not available on any national stock exchange. These REITs must register with the SEC. However, unlike stocks, it's not easy to buy and sell them via an exchange. A share in a public non-listed REIT has limited liquidity, as investors can only sell them through a repurchase program or a secondary market.
Regardless of whether REITs are private or public, an investor does not have direct ownership of the assets. Rather than owning real property, REIT investors own securities.
How to 1031 Into a REIT
Can you 1031 into a REIT? If you would like to buy shares of publicly traded REITs with proceeds from selling your rental or business property, this will not qualify for a 1031 exchange. You will be subject to depreciation recapture tax and capital gains tax.
Depending on specifics about the real estate asset you are looking to sell, moving to a REIT investment from direct ownership can be a costly investment strategy. Fortunately, you may have other options to receive this tax benefit.
Using 1031 Exchanges
A REIT is selective with the real estate properties it acquires. For example, you may have difficulty finding a REIT that wants to buy your small apartment building. While converting a 1031 into a REIT is not directly possible, you may be able to do a 1031 exchange and buy an interest in real estate that a REIT holds.
An umbrella partnership REIT, also known as an UPREIT, offers a unique solution to real estate investors who want to exchange an investment property for REIT shares and defer their capital gains tax. When you have an UPREIT, an operating partnership owns the real estate. The REIT is the sole general partner and owns a significant share of the OP units.
To defer your capital gains tax, you can use an UPREIT and contribute your property to the OP in exchange for OP units. You will not own shares of the REIT, but you will own units in the operating partnership.
About 1031 Exchanges and DSTs
Another option for deferring taxes in an exchange is with Delaware Statutory Trusts.
What Are DSTs?
DSTs are a type of partnership in which an investor owns an undivided interest in real property. The IRS allows an investor to use 1031 exchanges to defer the taxable gain if they then use the proceeds to invest in a DST property.
Doing a 1031 into a DST is the same process as a typical 1031 exchange. The time frames are the same and the seller also works with a qualified intermediary. Regulations differ in a DST's operation and structure.
Benefits of DSTs
While you may believe you are looking for a REIT, you might be searching for a DST. The benefits of DSTs include the following.
- Diversification: You can choose to split your investment across several properties to diversify your portfolio.
- No management responsibilities: If you want to invest in real estate without the commitment of management, a DST can be an excellent investment option. Instead, a team of experienced managers will handle the decision-making and daily oversight.
- Regular distributions: While a DST can keep cash reserves in case a property faces unexpected expenses or requires repairs, DSTs must regularly distribute proceeds and earnings above a specific reserve amount to beneficiaries within the expected time frame.
- Invest the amount that works for you: When investing in real estate, investors can quickly overextend themselves financially. Fortunately, when you invest in a DST, you can choose the amount you want to invest, though there may be a minimum.
Disadvantages of DSTs
Of course, DSTs are not for everyone. Here are some of the disadvantages of DSTs.
- Time commitment: A DST is often a long-term investment, and because it is not liquid, you may not want to commit to this investment for the required time.
- Lack of control: With DSTs, you will be relinquishing your management responsibilities. While many investors welcome this, you may want to retain more operational control and make management decisions. If so, a DST may not be the right investment option for you.
- Lack of ability to raise new capital: Neither you nor other investors can make additional contributions to a DST, so property maintenance can reduce the amount of the profit you receive. Before investing, research what Capital Expense Reserves are set in the PPM.
If you are still unsure whether DSTs are right for you, 1031 Crowdfunding can advise you further.
At 1031 Crowdfunding, we offer a turnkey solution for your 1031 exchange. Our experienced team of securities and real estate professionals has created an online marketplace of fully vetted real estate offerings. We provide inspired solutions to our clients to allow them to invest with confidence. Our DSTs give 1031 exchange investors a potential backup plan, so you can rest assured that we will invest exchange funds in replacement properties instead of taxing them for capital gains.
Along with DSTs, we also have opportunity zone funds, real estate investment trusts, bridge funds and other real estate investment funds. If you are interested in a 1031 exchange, join the crowd by registering for an investor account today.