In a 1031 Exchange, one of the most common challenges that property owners face is finding a suitable replacement property. Between the competition for the best exchange assets and the time constraints that must be adhered to, the search for a replacement property can be stressful and time consuming. As such, it is common to look for other options that qualify as a replacement property, but are much less stressful and competitive to acquire. One of the options frequently considered is a Real Estate Investment Trust (REIT).
In this article, we will explain whether it is possible to do a 1031 exchange into a REIT, as well as explore other options. But first, it is necessary to define two key terms: 1031 Exchange and REIT.
What is a 1031 Exchange?
A 1031 Exchange – sometimes called a like-kind exchange – is a specialized type of real estate transaction that allows an investor to defer capital gains taxes on the profitable sale of an investment property (the Relinquished Property) as long as they “exchange” the sale proceeds into another property (the Replacement Property) that is considered “like kind.” A 1031 Exchange is named after the section of the Internal Revenue Tax Code that permits it and outlines a number of rules that a taxpayer must adhere to when completing the transaction.
1031 Exchange Rules to Consider
Within the context of this article, there are two rules for a 1031 Exchange that are particularly relevant.
First, the replacement property must be “like kind” to the relinquished property. IRS rules define like kind as a property that is “of the same nature or character.” Property class or condition does not matter and most real estate is considered like-kind to other real estate as long as both properties are located in the United States and are held “for productive use in a trade or for business or investment.” For example, an office building is like-kind to an apartment building or a retail shopping center is like-kind to a warehouse.
2. Time Constraints
Second, real estate investors must identify the replacement property within 45 days of the sale of the relinquished property and the transaction must be completed within 180 days. It is just this time constraint that can make the search for a replacement property stressful. If one is not found in time, the transaction could become taxable.
What is a REIT?
A real estate investment trust (REIT) is a specialized type of investment vehicle that provides investors with exposure to commercial real estate assets without the hassle of actually owning it. Shares in REITs can be publicly traded – meaning they can be bought and sold like stocks, bonds, and mutual funds – which provides investors with a degree of liquidity not normally available in real estate. Or, REITs can be privately traded, which means they are only available to accredited investors who meet certain income and net worth requirements.
Can REITs Be Used as Replacement Property in a 1031 Exchange?
In short, no, it is not possible to use REIT shares as a replacement property in a 1031 Exchange. When considering whether or not a REIT investment can be used as a replacement property in a 1031 exchange, the key point is this: when an investor allocates capital to a REIT, they are not purchasing actual real estate. They are purchasing shares in a company that owns real estate, which entitles the investor to a portion of the cash flow and profits produced by the underlying assets.
1031 Exchange rules stipulate that the transaction must involve “real” property, which is the physical, tangible structure of real estate. Because an investment in a REIT involves shares of stock, they are not considered like-kind to physical real estate. So, for example, an investor could not receive the capital gains tax deferral benefits of a 1031 Exchange if they used property sale proceeds to purchase shares in American Tower (NYSE: AMT), which is the largest publicly traded REIT in the United States.
However, there is an alternative and it involves using the sale proceeds to invest in a specialized type of REIT called an “UPREIT.”
UPREIT: An Alternative Solution in a 1031 Exchange
UPREIT is an acronym for Umbrella Partnership Real Estate Investment Trust and it can provide an alternative solution to investors looking to exchange property sale proceeds into a REIT.
In an UPREIT, the real estate properties are owned within an “Operating Partnership” where the REIT is the general partner that owns a majority portion of the operating partnership units (OP Units). To defer capital gains, investors can contribute their property to the operating partnership in exchange for Operating Partnership Units. Upon completion, the investor does not actually own shares of the REIT; they own units in the Operating Partnership that owns the properties.
Section 721 Exchange Rules
An UPREIT transaction is sanctioned by IRC Section 721, which states that “…no gain or loss shall be recognized to a partnership or to any of its partners in the case of a contribution property to the partnership in exchange for an interest in the partnership.” As long as the UPREIT continues to hold the property and the investor continues to hold the Operating Partnership Units, capital gains taxes are deferred indefinitely.
Pros and Cons of a 1031 Exchange into an UPREIT
For an investor, the primary benefits of the UPREIT approach are simplicity and speed. Contributing property to an operating partnership is a less stressful and more efficient way of finding a “replacement” property in a 1031 Exchange. In addition, this is a passive investment, which allows investors to collect dividends from their shares in the partnership.
However, REITs are selective. They aren’t going to let every single property into the UPREIT. Typically, they are looking for large, institutional quality assets that will be beneficial to the partnership. Unfortunately, these are not the properties that most individual investors own. So, despite the fact that the transaction can be more simple from a process perspective, it can be more challenging to actually get the property into the partnership. Fortunately, there are alternatives.
Alternative Replacement Properties that Aren’t an UPREIT
For investors seeking alternative replacement property options that aren’t an UPREIT, there are two that are common, Tenants in Common (TIC) properties and Delaware Statutory Trusts (DST).
Tenants In Common (TIC)
In a Tenants In Common ownership structure, an individual can sell their property and use the proceeds to purchase a fractional share of an institutional quality asset. This is accomplished because the property is titled as “Tenants In Common.” When an investor purchases a share of the property, this means that they become part of an ownership group and can qualify for full tax deferral as long as the group adheres to a set of rules defined by the IRS.
Delaware Statutory Trust (DST)
In a Delaware Statutory Trust, an investor can sell their property and use the proceeds to purchase an interest in a specialized type of trust that owns and operates an institutional quality commercial real estate asset. IRS Revenue Ruling 2004-86 permits a DST Investment/DST Property to be used as a replacement in a 1031 Exchange. DST investment opportunities are offered by many major real estate firms and can be easily discovered through a simple internet search.
Depending on the specific needs of a real estate investor, their return requirements, risk tolerance, and time horizon, a TIC or DST may be a better fit than an UPREIT.
Conclusions & Summary
A 1031 Exchange is a specific type of real estate transaction that allows an investor to defer their liability on a taxable gain realized from the sale of an investment property. While they can provide major tax benefits, one of the challenges in a 1031 Exchange is finding a suitable replacement property within the defined time constraints.
Given this challenge, investors commonly seek out alternatives to be used as a replacement property, one of which is a REIT. On a standalone basis, using a property’s sale proceeds to purchase shares in a REIT is not permissible under Internal Revenue Code rules. However, an investor can contribute their property to an “UPREIT” in exchange for shares of the Operating Partnership.
Contributing property to an UPREIT results in full capital gains tax deferral, dividends, and passive involvement. But, UPREITs can be very selective about the properties that they admit, so it isn’t always guaranteed that an investor’s property will be allowed in.
As an UPREIT alternative, investors can use their sale proceeds to purchase a fractional share of an asset using the Tenants In Common (TIC) ownership structure. Or, they can use the sale proceeds to purchase shares in a Delaware Statutory Trust (DST). Both TIC and DST qualify for full tax deferral under 1031 Exchange rules.
1031 Exchanges can be complicated transactions and all investors considering one should consult with their tax advisor, attorney, and/or CPA prior to beginning the process. In addition, they should always use a qualified intermediary to ensure the transaction runs smoothly and within the designated time frames. Otherwise, it could become a taxable event.
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