It is a good idea to diversify your portfolio with real estate as a strategy. If you want cash flow from real estate without having to manage it, a real estate investment trust can be a good investment option.
Can 1031 exchange into a REIT? REITs are not eligible for 1031 exchanges. UPREITs and Delaware Statutory Trusts (DSTs) are alternatives for capital gains deferral.
A multi-step process is presented in this guide to help you successfully defer capital gains taxes by investing in REITs.
What Is a REIT?
An income-producing real estate investment trust operates, owns, and finances income-producing properties. Investing in REITs combines funds to buy assets and hold them in a portfolio. Real estate investment trusts do not own the real estate directly but rather own shares. In a REIT company, real estate properties are managed, rent is collected, and income dividends are distributed to shareholders.
Because a 1031 property is considered real estate, whereas a REIT is regarded as personal property, exchanging a REIT for real estate is impossible. The IRS defines an investment property as a tangible asset. Investors can defer capital gains taxes by exchanging like-kind support for an investment property following IRC Section 1031. Because REITs are not technically like-kind assets, investors cannot perform a 1031 exchange into one. It is possible to achieve similar tax deferment results, which we will cover later in this article.
There are several REIT types, each of which invests in a particular asset class. Public REITs and private REITs are the two main types of REITs. Investors do not directly own assets in REITs, whether public or private.
REITs owned by private investors
Non-stock exchange-listed REITs are not registered with the Securities and Exchange Commission (SEC). Usually, only accredited institutional investors can purchase shares in a private-placement REIT. The absence of a public REIT makes a private REIT a less liquid investment.
Public REITs
There are two types of public REITs:
Public traded: Real estate investment trusts (REITs) are often publicly traded, making them easier to invest than real estate assets since they can be bought and sold like stocks; publicly traded REITs are liquid investments.
Non-traded REITs are not listed on national stock exchanges. Securities and Exchange Commission registration is required for REITs. They can’t be bought and sold via a sale, unlike stocks. REIT shares have limited liquidity because they cannot be sold or repurchased on secondary markets.
1031 Exchange Alternatives to REITs
The purchase of shares of publicly traded REITs with proceeds from the sale of your rental property is not permitted because investment property owners cannot 1031 into a REIT. Depreciation recapture tax and capital gains tax will be applied. Consider these alternatives instead:
UPREITs
UPREITs offer a unique solution to real estate investors looking to exchange investment properties for REIT Operating Partnership (OP) units. In a UPREIT, the real estate is owned by an Operating Partnership. OP units are owned primarily by the REIT, the sole general partner.
In exchange for OP units, you can contribute your property to a UPREIT to defer your capital gains tax. As an Operating Partnership unit owner, you will not own shares of the REIT.
There is the possibility of exchanging a UPREIT for a REIT. For DST investors with DST interests, many REITs offer UPREITs to convert them into OP units. By transforming into a partnership, you can defer capital gains taxes.
One disadvantage of the UPREIT process is that you cannot convert the UPREIT back into real estate through a 1031 exchange. Tax deferral is only possible with UPREIT OP units.
DSTs and 1031 Exchanges
Delaware Statutory Trusts are another option for deferring taxes in exchange. Through a 1031 exchange, you can purchase an interest in a DST property. IRC Revenue Ruling 2004-86 considers DSTs to be like-kind assets.
What Are DSTs?
DSTs are partnerships in which an investor owns an undivided interest in real estate. Investors can defer taxable gains through 1031 exchanges if they use the proceeds to invest in DST properties.
Doing a 1031 exchange into a DST is similar to a typical 1031 exchange. Sellers work with qualified intermediaries in the same time frames. The operation and structure of a DST are regulated differently.
Investing in DSTs has both pros and cons. Please get in touch with investment.org if you have any questions about DSTs.
721-Optioned DSTs
The DST and REIT structures can be combined to invest exchange funds in a DST. Through a 721 exchange, the DST process allows exchange funds to be reinvested into REIT shares tax-neutrally. The process is as follows:
- The 721 option identifies a DST.
- You purchase DST.
- DST contributes your purchased assets to your REIT portfolio after a waiting period.
- In exchange for the contribution, the REIT issues units in its Operating Partnership.
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