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Tax Deferred Exchange for Investment in REITs?

Real estate investors frequently ask the question “Can I do a 1031 exchange of the relinquished property proceeds into a REIT (Real Estate Investment Trust) as replacement property?” The answer is actually yes and no as it can be done through a 2-step process but not directly.

What is a REIT and How is it Characterized?

REITs are entities that own and manage portfolios of real estate that are typically diversified by industry, geography and tenant and there are many features to REITs, including professional management, diversification and the potential for current monthly dividends and stock growth. However, an investor cannot do a 1031 exchange into shares of a REIT because the shares of a REIT are considered personal property even though the REIT, at the entity level, owns real property assets. Investors seeking 1031 exchange tax deferral must exchange property that is considered “like-kind” property which means exchanging real property held for investment or business purposes for other real property held in the same manner. REIT shares are not like-kind to real property.

A New Replacement Property Strategy For Investors

However, although investors cannot perform a 1031 exchange into a REIT, there is a creative two-step approach that can allow investors to essentially own the equivalent of shares in a REIT.

2 Step Process Facilitates Potential Investment in a REIT

Step #1 -1031 Exchange into a DST: An investor exchanges into a Delaware Statutory Trust (DST) that offers the potential to do an UPREIT pursuant to IRC §721 at a later point in time into operating partnership units (OP Units) in a REIT. A DST is a structure that offers fractional ownership of real property and qualifies for tax deferral. A DST has many benefits including the ability for investors to exchange out of actively managed real property and into a passive investment in a fractional ownership of institutional grade replacement property with high quality commercial tenants.

Step #2 - UPREIT from the DST into OP Units of a REIT: The investor utilizes IRC §721 and performs an UPREIT from their DST shares into operating partnership units (OP Units) in a REIT. The OP Units typically have all of the benefits as direct ownership in a REIT and are convertible into REIT shares. The UPREIT is a tax deferred transaction under IRC §721. Generally the investor is able to maintain tax deferral as long as the OP units are held. If the REIT shares are publicly traded, shares can be sold on the open market for cash. Conversion of OP units to REIT shares by the owner does create a taxable event, however, investors may choose to stagger those conversions for liquidity and tax management purposes. In addition, upon an OP Unit holder’s death, the beneficiaries of the OP Units will receive a stepped-up basis in the OP Units, similar to real estate, thereby providing greater tax planning flexibility.

Alternative Tax Management, LLC is an educational platform focused on tax mitigation strategies for accredited investors and their advisors. Holistic tax centric planning solutions are provided through a nationwide network of financial advisors, accounting, legal, real estate, and insurance professionals.


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