One of the most common questions among real estate investors: Can I complete a 1031 (like-kind) exchange by rolling capital gains from an investment property into purchasing shares of a real estate investment trust (REIT)?
Directly exchanging into a REIT does not qualify for tax deferral under IRS rules, for reasons we’ll explore below. However, two compelling alternative vehicles exist that check many of the same boxes that REITs do, allowing investors to still delay tax obligations while accessing exposure to institutional-quality real estate assets.
We’ll explore both of these REIT-like options: the UPREIT (umbrella partnership real estate investment trust), also commonly known as the 721 exchange, and the Delaware statutory trust (DST), both of which enable participation in diversified portfolios of professionally managed properties while continuing tax deferral.
Sign up for Kiplinger’s Free E-Newsletters
Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.
Profit and prosper with the best of expert advice - straight to your e-mail.
Let’s examine these instrumental strategies for unlocking real estate investments without triggering immediate capital gains tax burdens.
Exchanging into a REIT disqualifies tax deferral
First, why does the simple act of swapping directly into a REIT not qualify for a 1031 exchange? On the surface, it would seem to follow logically that a REIT would qualify as the “like-kind” asset needed to complete a 1031 exchange since REITs focus on owning and operating commercial real estate assets.
The IRS politely disagrees, however, holding that REIT shares are personal property, not real property. There is indeed real property that serves as the underlying investment, but the REIT investor has no direct claim, control or specific legal rights over any of the assets held by the REIT structure itself. Instead, REIT shareholders have a paper asset, affording no tangible rights to use, access or dispose of the properties in question.
Additionally, while REITs have predominant exposure to real estate assets, many also generate substantial ancillary revenue streams from activities like lending, advisory services, development and securitization, well beyond straight property acquisition, management and disposition. These secondary revenue streams further serve to undercut the argument that a REIT would be a like-kind investment in a 1031 exchange when relinquishing a piece of real estate investment property fully owned by the investor.
UPREITs to the rescue: The magic of a 721 exchange
Enter the 721 exchange, or the UPREIT. This increasingly popular financial structure allows REIT vehicles to bake in tax-deferred exchange capacity through a paired operating partnership tied to the REIT itself.
Here’s how it works in brief:
- A public REIT establishes or takes a controlling ownership stake in a separate operating partnership
- Investors directly contribute investment property into the operating partnership, in exchange for fractional ownership units in the UPREIT
- Operating partnership units received can be exchanged, without triggering tax liability, to eventually redeem fractional ownership equity directly in the founding umbrella REIT
In other words, directly contributing investment real estate into the underlying operating partnership tied to a REIT addresses the IRS’ definition of like-kind property. The operating partnership units serve as connective tissue, allowing 1031 investors to redirect tax liability through the continuity of direct ownership interest in like-kind property assets.
The UPREIT approach has proven popular in recent years. Over $100 billion in commercial real estate assets now use such partnerships to enable tax-deferred injections from 1031 exchangers seeking to roll over their gains.
Blue-chip REITs like Prologis, Digital Realty Trust, Vornado Realty Trust and W.P. Carey not only pioneered 721 exchanges to enable steady growth through tax-efficient asset pooling but continue to use them as such today. The structure has an established history of providing capital, liquidity and scale while often rewarding contributing partners.
Exploring the powerfully flexible Delaware statutory trust
While UPREITs provide scalability and professional management access, more tailored high-touch exposure also exists for those seeking greater involvement, control or niche sector participation absent the constraints of mammoth institutional vehicles.
Enter the Delaware statutory trust, a specialized trust that legally structures fractional beneficial ownership of commercial real estate assets among a pool of as many as 500 stakeholders. Unlike REITs, DSTs directly hold legal title to physical property assets like apartment communities, affordable housing sites, medical offices, self-storage facilities, retail power centers, industrial warehouses or specialty commercial developments among virtually all classes, with the goal of reliable occupancy and stable cash flows.
The direct ownership of multiple tangible assets then enables fractionalized sale of divvied-up beneficial interest to cohort investors, making a DST an attractive option for a 1031 exchange and even for the eventual division of an asset among multiple inheritors.
This effective framework is a boon for 1031 exchangers, allowing them the flexibility to redeploy capital gains into fractionalized shares in tangible fully owned properties. In addition, by directly deeding commercial real estate assets into a tailored DST and fractionalizing them into distinct equity shares (available for purchase by 1031 exchangers), specialized trust sponsors enable 1031 exchangers exposure to a higher-quality property portfolio that is generally not attainable by everyday investors.
Portfolios potentially spanning dozens of properties across both geography and sector mitigate the risks of concentration. Fractional shares translate into lower investment minimums, while direct ownership builds in the tax deferral that is central to the value of a 1031 exchange.
DST investors benefit from property management access, passive investment simplicity and diversification. DST structures also generally target stability and preservation of capital over higher-risk value-add or opportunistic plays — although sponsors continue to expand the risk/reward profiles as DSTs gain in popularity.
Ease of execution constitutes another desirable advantage over traditional physical 1031 exchanges. Investors need only wire proceeds and select a fractionally owned asset portfolio that fits their needs, as opposed to identifying potential swap properties, conducting physical inspections and due diligence, structuring financing and negotiating with the realization of deferred tax liabilities post-exchange.
The DST sponsor assumes responsibility for everything from acquisition and improvement to financing, compliance, accounting, reporting, customer relations, disposition and all administration. Investors can sit back, collecting distributions generated from assets now partially owned yet otherwise outside their ability to source or manage individually.
DSTs are also frequently used in tandem with UPREITs, particularly in cases where the DST is offered with a two-year 721/UPREIT feature. With this common setup, an investor will exchange into a DST, subsequently using a 721 exchange within a couple of years to move from the DST into a REIT. An experienced adviser will be able to handle all aspects of this transaction.
In sum, the DST combines flexible customization with institutional sophistication in a tax-efficient vehicle for savvy real estate investors looking for an alternative to simply rolling over into another piece of personally owned and operated real estate.
Think ‘best of both worlds’
While the traditional public REIT fails to enable a seamless 1031 exchange, both 721 exchanges/UPREITs and DSTs can bridge qualified investors into the stability, cash flow, appreciation and wealth preservation benefits of pooled large-scale institutional real estate investing.
For investors navigating the deployment of lump-sum capital gains from selling appreciated property, redirecting those gains into durable cash-flowing portfolios with the tax benefits of a 1031 exchange allows beneficial interest in assets that would otherwise demand deep expertise, even deeper pockets and disproportionate individual effort. Both vehicles blend the principal benefits of direct ownership with institutional access.
The ability to defer tax burdens into the future while still participating in stable value creation makes both the UPREIT and DST compelling solutions for shrewd investors contemplating redeployment of legacy investment proceeds.
Related Content
-
California Fires: How to Recover Tax Records and Other Important DocumentsDisaster Recovery Having your tax records and other vital documents is important for claiming casualty loss deductions that can help with recovery.
-
10 Reasons to Leave Your Heirs a Roth IRAIncluding a Roth IRA in your estate plan has clear tax advantages, which can be passed along to your heirs for years to come. But if passed down incorrectly, your heirs won’t reap the full benefits.
-
Social Security and Medicare Funding: Is the Sky Falling?Social Security and Medicare are slowly running out of money, but what does that mean for the retirees counting on them? Actually, it's not all bad news.
-
What We Need to Do to Protect Retirees' Financial SecurityCognitive decline and aging in general put older retirees at risk of losing their financial security when they're the most vulnerable. What can be done?
-
Is Money Messing Up Your Family's Life?Parents who discuss money and attitudes toward money with their children are more likely to raise financially successful and responsible adults.
-
Do You Know the Power of Whole Life Insurance in Retirement?Worried about legacy planning, market volatility or where to get cash to cover surprise medical or home repair bills? This little-known tool could help.
-
10 Ways Retirees Can Manage Income DistributionThe goal of a retirement income plan is to make the most of your money while ensuring that it lasts. These 10 strategies can help secure your financial future.
-
Gifting Earlier Rather Than Later Can Reap Big Tax BenefitsEven with Donald Trump's win, the future of the Tax Cuts and Jobs Act remains uncertain, so here's how to make the most of its provisions while you still can.
-
A Frugal Saver's Guide to Spotting Investment CostsSome of the fees that come with buying or holding stocks, bonds and other investments are obvious. Others can hide in plain sight.
-
Are Democrats or Republicans Better for My Insurance Premiums?Let's compare how these two political parties might affect your insurance premiums now that the 2024 election is over.
