It is Possible to Replace your Rental Property with a REIT… without Taxes!

It is Possible to Replace your Rental Property with a REIT… without Taxes!

The paramount principle of a 1031 exchange is to defer capital gains tax when you replace your business/investment real estate with other business/investment real estate. This is known as a “like kind” exchange, and today all real estate (including mineral rights and fractional interests) is “like kind” with all other real estate.  Click here for a summary of 1031 exchange requirements.

However, not all real estate satisfies the “business or investment” requirement of a 1031 exchange. Common exclusions are:

• Primary residence
• Property used as personal vacation property
• Developer inventory
• “Flip” property
• Investment vehicles that own real estate

In the last category are structures that seem like real estate—partnerships, real estate operating companies, LLCs and REITs—but do not qualify because technically the investor owns an interest in a company or partnership, not an interest in the underlying property.

More specifically: in a 1031 exchange, you cannot sell a rental property and re-invest the sales proceeds into a REIT. This may seem counterintuitive, but 1031 rules explicitly require taxpayers to replace their relinquished property with real estate they own directly.  The only exception to this rule is found in IRS Revenue Ruling 2004-86, which treats a beneficial interest in a trust created under Delaware law (subject to certain caveats) as a directly-owned fractional interest for 1031 purposes. Click here for a detailed overview.

But there is good news for those hoping to 1031 exchange today and own REIT interests in the future—without triggering capital gains taxes. This is known as the “1031/721 combo strategy” or simply the “UPREIT conversion” strategy. Here’s how it works:

• Sell your rental property today
• Conduct a 1031 exchange by investing your proceeds into a passive replacement property
• Own a fractional interest in an institutional property for 2-3 years
• The Operating Partnership (“OP”) of an “UPREIT” then acquires the property
  • UPREIT stands for Umbrella Partnership Real Estate Investment Trust
• Your interests in the property convert to REIT OP units under a tax-deferred transfer per
  IRC §721
• Thereafter, you own REIT OP units, which can be redeemed partially or entirely on a periodic basis beginning 12 months after the conversion
• REIT investors continue to claim their pro-rata share of depreciation (subject to personal cost basis) and ultimately benefit from a “step up” in cost basis upon death, thereby avoiding the deferred capital gains taxes altogether

In most cases, investors are committing to the REIT at the outset, while some programs may provide an option to cash out when the REIT acquires the initial 1031 property.  The same institutional real estate operator (known as the “sponsor”) who arranged the 1031 program will control the disposition of the property and also is affiliated with the target REIT.

Bottom Line: Trading your rental property for REIT interests is a two-step process, with 3-4 years before your shares become redeemable. When the dust settles, you have the opportunity to own a (fractionally) a diverse portfolio designed for the potential of consistent income, with continued depreciation and estate planning simplicity.

For more information on the 1031/721 combo strategy, click here.

For watch a video on this topic, click here.

For general information on passive replacement strategies, please visit our website at https://1031capitalsolutions.com/category/literature/.

RICHARD D. GANN, JD

Managing Partner

1031 Capital Solutions

(800) 445-5908

1031CapitalSolutions.com

Richard (Rick) Gann is an attorney, licensed real-estate broker, and general securities principal specializing in 1031 exchange solutions and he is co-author of the book How to Retire from Being a Landlord.

DISCLOSURES

UPREITs may impose one or more of the following fees on 1031 investors: conversion fee, ongoing asset management fees, liquidation fee.

Consult with your legal or tax professional before investing.

This is for informational purposes only, does not constitute individual investment advice, and should not be relied upon as tax or legal advice. Please consult the appropriate professional regarding your individual circumstance.

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.

Potential cash flows/returns/appreciation are not guaranteed and could be lower than anticipated. 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.

A listed REIT is a security that sells like a stock on the major exchanges and invests in real estate directly, either through properties or mortgages. Non-listed REITs also invest in real estate directly, but their shares are not listed on an exchange; redemptions are limited and may be suspended. REITs receive special tax considerations and typically offer investors high yields, as well as a highly liquid method of investing in real estate. There are risks associated with these types of investments and include but are not limited to the following: Typically no secondary market exists for the security listed above. Potential difficulty discerning between routine interest payments and principal repayment. Redemption price of a REIT may be worth more or less than the original price paid. Value of the shares in the trust will fluctuate with the portfolio of underlying real estate. Involves risks such as refinancing in the real estate industry, interest rates, availability of mortgage funds, operating expenses, cost of insurance, lease terminations, potential economic and regulatory changes. This is neither an offer to sell nor a solicitation or an offer to buy the securities described herein. The offering is made only by the Prospectus.

Securities offered through Concorde Investment Services, LLC (CIS), Member FINRA/ SIPC. Advisory Services offered through Concorde Asset Management, LLC (CAM), an SEC- registered Investment Adviser. 1031 Capital Solutions is independent of CIS and CAM.

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