Pros & Cons of 1031 Exchange Into an REIT

Updated: Oct 25

There’s no way to perform a 1031 exchange and REIT simultaneously. However, with a little fancy footwork and planning, you could transfer your 1031 property to a REIT. Doing so might come with plenty of benefits.

Here’s what you need to know about what these financial tools are, how they work, and how you can take advantage of these opportunities. We’ll also explain why it’s not the right approach for everyone.

What Is a 1031 Exchange?

A 1031 exchange is a taxed-deferred opportunity to sell one investment property and buy another in one multi-part transaction. With this approach, you avoid the immediate potential taxes associated with the sale, as you roll them into your basis in the new property.

The IRS doesn’t allow an investor to hold two properties at once and avoid taxes. In a 1031 exchange, a qualified intermediary holds the money from the sale and releases it for the purchase of another. With this approach, the immediate tax concerns disappear.

A 1031 exchange only works when the two properties are considered like-kind. Real properties are like-kind to other real properties, but some types of investments aren’t like-kind to properties. This is an important concept to understand, and we’ll come back to it in a minute.

What Is a REIT?

A real estate investment trust (REIT) is a company that owns and operates assets like office buildings, hotels, apartments, and mortgages. As the U.S. Securities and Exchange Commission (SEC) explains, a REIT doesn’t develop properties to resell them. Instead, a REIT buys these properties to operate them as part of an investment portfolio.

Several types of REITs exist, including the following:

Publicly traded, which are bought and sold on national securities exchanges and regulated by the SEC
Public non-traded, which are regulated by the SEC but not traded on an exchange
Net value asset, which calculates value regularly and sells shares based on that price
Private, which aren’t regulated by the SEC or traded on national exchanges, and are typically sold to institutional investors

Can You Perform a 1031 Exchange REIT Directly?

Investors hoping to use a 1031 exchange to purchase a REIT are in for bad news. This type of direct transaction is not permitted.

As we explained earlier, the IRS requires properties in a 1031 exchange to be like-kind. That means real properties are like-kind to other real properties. However, real property is not considered like-kind to another kind of investment, like a REIT.

However, you can use a few different tools to convert your 1031 asset into a REIT investment. Keep reading to learn how.

How to Perform a 1031 Exchange REIT Indirectly

As we mentioned, there is a way to convert your investment to a REIT. The following financial tools are typically required:

Delaware Statutory Trust

A Delaware Statutory Trust (DST) is an organization or entity that holds a portfolio of real estate, such as apartments or office buildings. Several investors pool their money in a DST, allowing them to purchase an asset they might not be able to buy alone.

A DST is typically governed by a trustee, and the organization performs all of the day-to-day tasks associated with running the properties. This means you can invest without worrying about things like collecting rent or fixing broken appliances. This can be a huge stress relief for many investors.

DSTs are tailor-made for the 1031 exchange process. The transactions typically close quickly, allowing investors to meet the tight deadlines associated with an exchange. The IRS also considers these transactions like-kind, as they both involve investing in commercial or investment properties.

721 UPREIT

Some types of DSTs allow investors to use something called a 721 UPREIT. An umbrella partnership real estate investment trust (UPREIT) allows investors to trade their property for a share of the UPREIT ownership. This is typically considered a tax-deferred transaction, so you’re not required to pay the taxes you postponed from the 1031 exchange.

REIT

Some UPREITs allow investors to convert their investment into REIT shares. Unfortunately, this transaction is typically considered a taxable event, so the deferred capital gains would come due.

Drawbacks of 1031 Exchange REIT

While it’s possible to take all of the steps we’ve mentioned and transfer a 1031 exchange to a REIT in time, consider your options carefully, as this transaction can come with the following drawbacks.

Tax Implications

Converting your 1031 property into a REIT will come with a tax bill. The obligations you pushed forward with the exchange, along with any valuation you’ve added during your ownership, will be subject to taxes. For people who have used chains of exchanges to increase their portfolios, the financial implications could be massive.

Loss of 1031 Exchange Opportunity

Once you’ve followed all of these steps and converted to a REIT, you can’t use those funds in a future 1031 exchange. Essentially, you’ve cashed out your opportunities to use this tool in the future.

Lack of Control

Once you’ve finished your REIT conversion, you become a simple shareholder. You can vote on what you want done with the property, but you can’t make decisions individually. If you’re accustomed to having plenty of autonomy in your real estate transactions, this could be an unwelcome surprise.

Benefits of a 1031 Exchange REIT

While these complex transactions have some drawbacks, they can be attractive for some investors. Here are a few of the benefits:

Diversification

A REIT often involves a collection of many different types of real estate assets. If you’re accustomed to the stress of being heavily invested in one type of property (such as a suite of office buildings), the variety of holdings could be very appealing to you.

Professional Management

Many real estate investors are accustomed to handling the day-to-day difficulties that arise in their properties. If something breaks, they get the call. If someone moves out, they have to find a new tenant.

A REIT removes your daily obligations. If you want to watch your money grow without worrying about the day-to-day responsibilities or worry, this could be a good choice for you.

Liquidity

Depending on the product you purchase, your REIT could offer a great deal of liquidity. Unlike real estate, which often requires complicated transactions and multiple players, a REIT could allow you to pull out money as soon as you need it.

What Could You Try Instead?

While a 1031 exchange to a REIT is possible, it’s not the right choice for everyone. Thankfully, it’s not the only option available. These are other choices to consider, such as these:

Sell & Reinvest

Instead of trying to convert your 1031 exchange property into something else, consider selling the asset on the real estate market. You’ll face tax penalties when the sale is complete, but you’ll skip a lot of the procedural hassles associated with conversions and exchanges. This can be an easier option for many despite the tax implications.

Try Another 1031 Exchange

You can take an asset purchased with a 1031 exchange and sell it via another exchange. This process can allow you to push forward your tax obligations into the new property, so you won’t face the bills you might expect with other choices.

Get Help for a 1031 Exchange

The best way to keep your investment working—and the tax man at bay—is to try a 1031 exchange. At 1031 Pros, we specialize in handling these delicate transactions. We can ensure your transfer happens quickly and efficiently, and we’ll handle all of the paperwork required. Contact us to get started.