Many investors that are in a 1031 exchange that are tired of actively managing their investment properties and are looking to diversify* their 1031 exchange eligible equity as opposed to buying a single property again often ask themselves, “Can I 1031 exchange into a REIT?” The answer is yes—not directly—but indirectly, as part of a multi-part process.
An investor is not able to do a direct 1031 exchange into a REIT since REIT shares are not considered “like kind” property by the IRS for the purposes of a 1031 exchange. However, the investor may purchase an interest in a Delaware Statutory Trust – DST property – via a 1031 exchange under IRC Revenue Ruling 2004-86 which qualifies a DST as “like kind.”
In certain DSTs, after the investor purchases the DST interest and time passes, the DST (and the real estate in it) could be called into the REIT as part of its business plan and the investors could utilize a section 721 exchange to exchange their DST interests, on a tax deferred basis, for shares of the REIT’s operating partnership (also known as OP Units). The OP Units are typically convertible on a one-for-one basis with the REIT’s common stock. It should be noted that this strategy is not part of every DST’s business plan, and if it is, there are no guarantees that the exit would be through an UPREIT/721 exchange.
Now the investor has deferred his/her taxes via the 1031 into a DST and via the 721 from the DST into the REIT. Now that this explanation has answered the “Can I 1031 Exchange into a REIT” question, we must explore some often left out implications investors must be aware of.
Once an investor does the section 721 conversion into the REIT, he/she can NEVER do another 1031 exchange again with that equity. The second they sell their REIT shares, they are immediately taxable. So, all of the Federal Capital Gains (15-20%), State Capital Gains (0-11.3% depending on the state he/she lives in), Depreciation Recapture Tax (25%) and the Medicare Surtax (3.8%) will now be due upon sale. This final tax bill for many investors may be very large due to the investor having utilized 1031 exchanges for many years and the tax bite could potentially be significant. After learning this fact, many of our clients seriously consider whether the 1031 exchange into a REIT would be a worthwhile endeavor.
It should be noted that many Non-Traded or private REITs often are not liquid— something to think about for many investors as they consider potential prospects for their real estate holdings/tax-deferral expectations, etc. An investor would have to be comfortable with never doing a 1031 exchange again and would also have to acknowledge the potential reality of paying taxes upon sale of the REIT shares. Our investors have often decided that the risk of Non-Traded REITs and their spotty track records (although some have done well for investors) is not worth the exercise.
The articles below show published examples of the risks of investing in Non-Traded REITs:
https://seekingalpha.com/article/1955411-dumb-investment-of-the-week-public- non-traded-reits
https://www.wsj.com/articles/latest-fear-for-property-investors-zombie-reits-1427221093
*Diversification does not guarantee profits or protect against losses.
