According to the rules defined by the IRS, a 1031 exchange is a swap of an investment property with a like-kind investment property to defer the accumulated capital gain taxes on your sales proceeds. And, if you are thinking of doing a 1031 exchange in a REIT, things can be slightly complicated.
For starters, REITs are not classified as like-kind investment properties. However, it is possible to do a 1031 exchange in a REIT.
Here’s how to do a 1031 exchange REIT in a simpler way:
Understanding Real Property And Securities
The IRC Section 1031 allows investors to sell their investment property and reinvest 100% of the sales proceeds in one or multiple like-kind investment properties to defer the taxes on their capital gains and depreciation recapture.
REITs are trusts that handle real estate properties. However, the mode of investment is slightly different. In short, REIT buys investment properties and secures them in a portfolio. Investors, then, invest in this portfolio rather than actually investing in the property. Moreover, because the profit comes from the dividend and not rental income, REITs are identified as securities.
So, to do a 1031 exchange REIT, you can not just directly invest in a REIT. This is true because they are not like-kind investment properties. However, there’s another way to make the process successful.
How To Do A 1031 Exchange In REITs?
To get started, you must transition from being a property owner to a REIT investor. This can be done by investing in DSTs. Once invested, you can convert your DST ownership into Operating Partnership (OP) units with the help of Umbrella Partnership Real Estate Investment Trust (UPREIT).
So, if you have made up your mind to invest in REIT, you would have to convert your DST ownership into OP units through UPREIT. In fact, because this is an immensely common practice, many REITs offer UPREITs for DST investors. And because this conversion makes you a partner, you can defer the capital gain taxes on your proceeds unless you decide to convert UPREIT OP units into REITs.
That being said, there are several benefits and downsides to this process.
Here’s why a 1031 exchange REIT process is beneficial:
You can not just sell off your real estate property in an instant to earn money. What we’re saying is real estate properties are not liquid. You would have to go through a long process of exchanging and selling the property to gain proceeds. REITs, on the other hand, are considered securities. This makes them highly liquid. Meaning, you can sell them anytime and get your investment back. However, remember; that you’ll be creating a taxable event.
It Allows Diversification
Rather than investing in a single investment property, the 1031 exchange REIT process allows you to invest in an entire portfolio of investment portfolios. This allows you to diversify your investment portfolio.
It Accelerates Estate Planning
It’s true that once you invest the proceeds in a REIT, or more precisely UPREIT OP units, you can not sell off the security and defer the taxes on your proceeds by reinvesting it again. However, you can eliminate them completely if you pass down the REIT to your heir, given you have not converted the UPREIT OP units into REITs.
So, in addition to helping you diversify your portfolio and gain higher liquidity, UPREITs also help in estate planning. However, there’s one major downside of investing in UPREITs.
Once you complete a 1031 exchange REIT process, there’s no going back. In short, you can not 1031 exchange a REIT into an investment property to defer taxes. If you wish to sell the REIT, you must pay the capital gains taxes on it.
The Bottom Line
Investing your 1031 exchange proceeds in REITs to defer the capital gains taxes is possible. And, while you won’t be able to do a 1031 exchange indefinitely on them, it would give you a chance to expand your portfolio and gain access to highly-liquid securities. That being said, it is important to keep the 1031 exchange rules and timeline in mind to successfully complete the process.