Capitalizing on Sections 1031 and 721 for REIT Investments – With a Look at the Potential Pitfalls

Navigating the complex terrain of real estate investment can involve sorting through rules for complex tax deferral strategies such as the 1031 exchange. While 1031 exchanges are an established tax deferral tool, there are other potential strategies that may be available to investors to defer capital gains taxation, such as the “721 Exchange.” Certain investors can use this strategy to invest in a REIT (“Real Estate Investment Trust”) after completing a 1031 exchange, an action that cannot be achieved directly through a 1031 exchange. This is typically accomplished via the investor’s acquisition of beneficial interests in a Delaware Statutory Trust (“DST”), which are later converted into REIT shares through a series of steps. For investors whose financial advisors have instructed them that REIT investment after an exchange will provide the best flexibility and tax advantages for their circumstances, understanding these mechanisms is essential to a successful transaction. However, there may be some downsides to REIT investment, which taxpayers should be aware of.

Understanding the Basics: REIT Interests Cannot be Exchanged Directly

A 1031 exchange, governed by Section 1031 of the Internal Revenue Code (“IRC”), allows a taxpayer to defer capital gains when selling investment property by reinvesting the proceeds into a new property of like kind. The exchange must occur within specified time limits, and both the relinquished and replacement properties must be real property, held for investment or productive use in a trade or business.

A REIT is an entity set up to own a portfolio of real property, and it operates and manages that property, distributing dividends to its shareholders. Acquiring shares in a REIT as replacement property in an exchange is not possible because those shares are not considered interests in real property for federal income tax purposes – the investor is deemed to own personal property, rather than a direct interest in the underlying real property. Personal property is excluded from 1031 treatment as of the Tax Cuts and Jobs Act of 2017. Nevertheless, there are potential pathways to enable integration of a 1031 exchange with REIT investments, such as by taking advantage of an UPREIT (“Umbrella Partnership Real Estate Investment Trust”) structure. In this structuring, a taxpayer can utilize Section 721 of the IRC, which allows for non-recognition of gain or loss when a taxpayer contributes property to a partnership in exchange for operating partnership units (“OPUs”). Read more on this process, below.

Why a REIT Investment?

There are some potential downsides to being invested in a REIT entity, as compared to a more typical investment in real property acquired through a 1031 exchange. Taxes are paid on dividends when a taxpayer owns REIT shares, and there is generally no exit strategy – once an investor has converted ownership of their property to UPREIT shares, the shares are considered personal property and not eligible for 1031 exchange. Some financial advisors find that REIT investment does not typically perform as well as direct investment in an individual property or a DST interest. That being said, there are certain advantages to REIT investments that may draw some investors to want to participate in a 721 Exchange UPREIT transaction. REITs can pay cash distributions and dividends to their shareholders – passive income can be a draw for investors. They also offer the possibility for an investor to more easily diversify their investments. With the ability to convert their ownership units in the UPREIT to common shares, they may have higher liquidity potential – those shares can be sold and converted to cash more easily than a typical real property interest. Ownership of operating units in an REIT is also easy to manage by heirs and executors in the context of estate planning.

As discussed above, REIT shares cannot be acquired through a 1031 exchange, as they don’t constitute real property for income tax purposes. An investment type that does qualify for exchange, however, is a beneficial interest in a DST. A DST is a unique type of investment trust established under the laws of Delaware. It is controlled by a third-party trustee with the beneficiaries considered the owners of the underlying portfolio of real property for income tax purposes. This was established in Revenue Ruling 2004-86, allowing a beneficial interest in a DST to qualify as like-kind real property in a 1031 exchange. DSTs are often favored by taxpayers identifying replacement properties in an exchange because of their ease and flexibility for identification purposes, the passive nature of the investment, and the ability to diversify their portfolio. However, DSTs typically only remain invested for a period of years. At the end of the investment period, the investor can complete another 1031 exchange if they wish to continue deferring taxation on their capital gains.

When a 721 Exchange Follows a 1031 Exchange

With all the above in mind, how might an investor in real estate defer capital gains through a 1031 exchange and still be able to invest in a REIT without triggering immediate capital gains liability?

1. The investor begins by selling their investment property and identifying potential DST replacement properties, owned by DSTs sponsored by an UPREIT, within the required 1031 timelines.
2. Some time after the exchange has concluded, or most typically, when the DST sponsor is preparing to sell an existing property or portfolio, the DST will roll over the investment into an UPREIT entity (which often owns other properties as well). In exchange for their beneficial interests in the DST, its investors receive OPUs in the UPREIT. This transaction falls under IRC Section 721, which allows for non-recognition of gain or loss for this sort of exchange of property for partnership interests (the “721 Exchange”). This step allows an investor to take advantage of an opportunity for investment in a REIT without triggering immediate tax consequences.
3. The OPUs can later be converted into REIT shares by the investors. However, the investor must pay capital gains taxes at the time of that conversion. REIT shares offer potential for income through dividends and growth in share value.
4. A future step can involve the conversion of the REIT back into a DST after a period of time. This conversion is particularly strategic as it positions the investor to potentially exit the investment through another 1031 exchange, thus continuing the cycle of tax deferral. However, this exit strategy is not available to an investor who has already converted their OPUs into REIT shares.

Final Considerations

The 1031 exchange to 721 exchange pathway involves several complex stages, requiring careful planning and advice from specialized tax advisors and legal professionals. Each step from the initial 1031 exchange, through selection, identification and acquisition of DST interests in the proper investment vehicle, to eventual conversion into OPUs and potential further conversion into REIT shares, must be meticulously structured and planned to comply with IRS regulations and to ensure the preservation of all desired tax benefits. Your tax advisors will help ensure you are asking the right questions to achieve your ultimate goal, and at First American Exchange Company, we are always standing by to answer questions as they pertain to the 1031 elements of the transaction.

The integration of 1031 exchanges, UPREITs, and DSTs can provide a sophisticated strategy to manage and grow real estate investments while deferring taxes. This approach, while not suited for all investors, may offer benefits such as greater liquidity and diversification while reducing management burdens typically associated with direct property ownership. Moreover, for investors looking towards a gradual transition out of active property management or diversification into different markets without immediate tax implications, this strategy offers a compelling pathway. However, these goals might be achieved by investing in a DST without participating in a 721 exchange, and an investor may find it more advantageous to avoid a path where their DST interests are converted into OPUs. This article serves as an educational tool to help investors recognize opportunities and potential issues in their investment journey. For more detailed guidance tailored to a specific situation, consulting with a tax or legal advisor is strongly advised.