1031 Exchange, 721 UPREIT, and Real Estate Investment Trusts

“Can I 1031 exchange into a REIT (Real Estate Investment Trust)?”

Clients often ask this question when we discuss the options available for 1031 exchange. The answer, like many things in tax, is nuanced. 

The short answer is “No.” REITs are corporations that own investment real estate or real estate-related assets and receive special tax treatment of their dividends by adhering to specific IRS rules. Many are publicly traded like your favorite blue-chip stocks, offering the ability for liquidity and daily price changes. Despite underlying real estate ownership, REIT shares are not considered “Real Property” and therefore do not qualify for the 1031 exchange.

Though an investor cannot 1031 exchange directly into a Real Estate Investment Trust, the combination of IRC Section 1031 with IRC Section 721 can achieve a similar result. 

Keep in mind that there are potential benefits and potential drawbacks with any investment or tax strategy. Consult with the appropriate tax, legal, and financial professionals to find out what is suitable for you.

Section 721 Exchange

Most real estate pros know that Internal Revenue Code Section 1031 allows real estate investors to sell and purchase replacement property without recognizing capital gains. IRC Section 721 offers a similar mechanism. Instead of tax deferral on a property sale, a “721 Exchange” allows for tax deferral (nonrecognition of gain) on the contribution of property to certain partnerships. The contributed property can be cash, real estate, or securities. In exchange, the contributing party receives ownership interests in the partnership itself.

Putting It Together – 1031 Exchange, DST, and the 721 UPREIT (Umbrella Partnership Real Estate Investment Trust)

Fractional real estate investing through the Delaware Statutory Trust (DST) is an increasingly popular option for Accredited Investors seeking passive 1031 exchange property. In some DST investments, the business plan includes the possibility of acquisition by an affiliated REIT. When this occurs, and the REIT buys out the DST, investors may be able to exchange their ownership in the DST for units of the REIT’s Operating Partnership via tax-deferred 721 exchange. These units, known as OP Units, are typically convertible into the REIT’s common stock. This process is called a 721 UPREIT transaction and it would look something like this:

Property Sale ➡️ 1031 Exchange ➡️ DST Purchase ➡️  721 UPREIT exchanges DST Ownership for OP Units ➡️ Conversion of OP Units to REIT Common Stock

This series of transactions allows investors to exit actively managed property via 1031 exchange and end up with ownership of a large diversified portfolio of properties through a REIT, all while deferring tax liability.

Potential Benefits of the 721 UPREIT

There are several potential benefits of the 721 UPREIT strategy that may appeal to the 1031 exchange investor:

1. Diversification – Though DSTs are usually individual assets or small portfolios, REITs may contain hundreds of properties and billions in asset value. Shares or OP Units of a REIT will, therefore, provide more diversified exposure than your typical DST.
   
   
2. Liquidity – Shares of publicly traded REITs may be freely sold on the stock exchange. Private REIT’s may offer redemptions. In either case, clients may be able to sell or redeem some or all of their shares to generate liquidity. This can be useful for clients significant with unexpected medical bills or expectations of significant one-time expenses.
   
   
3. Estate Planning – Like fee simple real estate, beneficial interests in a DST and OP Units of a REIT both receive a “step-up” in cost basis at the time of death. This means that deferred gains or recapture burden is eliminated when heirs inherit. However, because DSTs are illiquid assets, an heir may not be able to exit for years. They will be forced to wait for the DST to execute a business plan and sell. In contrast, the inheritance of OP Units in a REIT offers the ability for an immediate exit thanks to the REIT’s liquidity features.

Potential Negatives of the 721 UPREIT

Though the listed benefits may appeal to some exchangers, there are trade-offs to be had as well:

1. No More 1031 – Neither OP Units nor REIT shares qualify as “Real Property” and are, therefore, not candidates for 1031 exchange. Exchangers that pursue a 721 UPREIT strategy do so knowing that they do not intend to perform future 1031 exchanges.
   
   
2. Tax Liability – Conversion of OP Units to common shares for redemption or sale will trigger recognition of the previously deferred tax liability. The 1031 exchange is no longer an option, so Uncle Sam comes calling.
   
   
3. Blind pool – DSTs are generally not considered to be “blind pool” investments because purchasers know precisely what is owned at the time of their investment. Additionally, the sale of DST property triggers the dissolution of the DST. As a result, there is no trading in and out of property within the DST structure. REITs have no such limitations. The REIT may buy or sell assets in an ongoing manner during the investment hold period.

If you would like more information on 1031 exchanges, DSTs, or 721 UPREITs, our team at Fortitude is happy to assist. Real estate transactions and tax law can be scary, but they don’t have to be. It’s never too early to assemble your team and begin planning with skilled professionals. Feel free to contact us to schedule a consultation!

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Important Disclosures

This is for informational purposes only and does not constitute as individual investment advice. There are material risks associated with investing in DST properties and real estate securities including liquidity, tenant vacancies, general market conditions and competition, lack of operating history, interest rate risks, the risk of new supply coming to market and softening rental rates, general risks of owning/operating commercial and multifamily properties, short term leases associated with multi-family properties, financing risks, potential adverse tax consequences, general economic risks, development risks, long hold periods, and potential loss of the entire investment principal. Past performance is not a guarantee of future results.  Potential cash flow, returns and appreciation are not guaranteed. IRC Section 1031 is a complex tax concept; consult your legal or tax professional regarding the specifics of your particular situation. This is not a solicitation or an offer to sell any securities. DST 1031 properties are only available to accredited investors (typically have a $1 million net worth excluding primary residence or $200,000 income individually/$300,000 jointly of the last three years) and accredited entities only. If you are unsure if you are an accredited investor and/or an accredited entity please verify with your CPA and Attorney.

PAST PERFORMANCE IS NO GUARANTEE OF FUTURE RESULTS
The case study does not reflect actual clients. Any reference to securities is based upon historical data that is public sourced. No statement made herein is to suggest stock market performance or future performance, and no case study is used to imply future performance. The case study is intended to illustrate services available through the adviser. They do not necessarily represent the experience of any clients. Fortitude Investment Group does not offer legal or tax advice. Please consult the appropriate professional regarding your individual circumstance. Diversification does not guarantee a profit or protect against a loss in a declining market.  It is a method used to help manage investment risk.

Securities offered through Concorde Investment Services, LLC (CIS), member FINRA/SIPC. Advisory services through Concorde Asset Management, LLC (CAM), an SEC-registered investment adviser. Insurance offered through Concorde Insurance Agency, Inc. (CIA). Fortitude Investment Group is independent of CIS, CAM and CIA.

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