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Issue 229 Article 368
Real estate investors are asking whether they can do an Internal Revenue Code Section 1031 exchange of the relinquished property proceeds into a Real Estate Investment Trust (REIT) as replacement property. As you may well know, REITs are business entities that own and manage portfolios of real estate that are typically diversified by industry, geography and tenant. There are many aspects to REITs such as; professional management, property diversification, the possibility of monthly dividends and stock growth that are appealing to investors seeking to invest in a diversified portfolio of real estate without being burdened with management responsibility. However, an investor cannot do an Internal Revenue Code Section 1031 exchange directly into shares of a REIT because the shares of a REIT are deemed by the IRS to be personal property even though the REIT itself owns real property. Investors seeking the benefits of Internal Revenue Code Section 1031 tax deferral must exchange property that is considered by the IRS to be "like-kind" property which means exchanging real property held for investment or business purposes for other real property held in the same manner. Thus, REIT shares are deemed to not be like-kind to real property.
Although real estate investors cannot structure an Internal Revenue Code Section 1031 exchange directly into shares of a REIT, some advisors are recommending a creative two-step approach that that they believe allows investors to essentially own the equivalent of shares in a REIT.
First Step – use Internal Revenue Code Section 1031 to exchange qualified real property into a Delaware Statutory Trust (DST): A DST is a structure that offers fractional ownership of real property and qualifies for tax deferral. The IRS issued Revenue Ruling 2004-86 in 2004 establishing the requirements for investing in DSTs as part of a 1031 Exchange transaction. A DST has many benefits including the ability for investors to exchange out of actively managed real property and into a passive investment in a fractional ownership of institutional grade replacement property with high quality commercial tenants. The DST also offers the potential at a later point in time of exchanging the membership interest into operating partnership units (OP Units) in a REIT which is referred to as an UPREIT or Sec. 721 exchange pursuant to IRC Section 721
Second Step – do an Internal Revenue Code Section 721 exchange from the DST into OP Units of a REIT: The OP Units typically have all of the benefits as direct ownership in a REIT and are convertible into REIT shares. The UPREIT is a tax deferred transaction under IRC Section 721. Generally the investor is able to maintain tax deferral as long as the OP units are held. If the REIT shares are publicly traded, shares can be sold on the open market for cash. Conversion of OP units to REIT shares by the owner does create a taxable event, however, investors may choose to stagger those conversions for liquidity and tax management purposes. In addition, upon an OP Unit holder's death, the beneficiaries of the OP Units will receive a stepped-up basis in the OP Units, similar to real estate, thereby providing greater tax planning flexibility .
Delaware Statutory Trusts are generally structured and sold (distributed) as securities and therefore must be purchased and sold through a securities representative. There are many DST Brokers and DST Sponsors that can provide you with guidance and advice regarding DST investment property ownership interests. DST Brokers typically work with numerous DST Sponsors and can better assist you in evaluating the various options and help you in making an educated and informed decision as to whether the DST investment property ownership interest is right for you.
Statewide Title Exchange Corporation can serve as your qualified Intermediary for your exchange into a DST, however we do not provide legal tax or financial advice in that regard, nor do we accommodate Internal Revenue Code Section 721 exchanges. You should always consult with your legal, tax and financial advisors prior to entering into any Internal Revenue Code Section 1031 exchange, Internal Revenue Code Section 721 exchange or Delaware Statutory Trust or DST investment property transaction, including the review of any Private Placement Memorandums (PPMs) or other offering material on Delaware Statutory Trusts or DST investment property interests. We will be happy to work with the advisors you select.