One of the attractive attributes in investing in real estate is the ability to defer gain on the sale of property using a like-kind exchange, also known as a 1031 exchange. In general, if you want to complete a 1031 exchange, owners of real property need to find replacement real estate to complete the exchange. However, there are a couple of alternative ways to complete the exchange without having to have a physical real estate property.
1031 Exchanges
A reminder of the basic rules of a 1031 exchange are as follows:
- Real property held for business or investment purposes can be exchanged for other real property also held for business or investment purposes.
- Money received from the relinquished property must be held by a qualified intermediary, which is usually a title company.
- An investor has 45 days to identify new replacement property and 180 days to complete the exchange.
- There are alternatives to a traditional 1031 exchange, including a Delaware Statutory Trust (DST) or an Umbrella Partnership Real Estate Investment Trust (UPREIT).
Delaware Statutory Trusts (DSTs)
A DST is an undivided fractional interest in a trust that owns only real estate. In addition, the trust typically holds a specific type of real estate, e.g., commercial, multifamily, etc. An investor who wants to invest in a DST must be an accredited investor. This means they must have $1 million in net worth and invest a minimum of $100,000 in a DST. The nice thing about DSTs is that an investor can invest in a DST quickly, i.e., about three to four days. This means that an investor can look for traditional real estate options, and if they are not able to find a replacement property, they can decide to use a DST instead. The problem with a DST is that it is an illiquid investment vehicle. Typically, it takes three to 10 years before an investor is paid out. If an investor is going to invest in a DST, they must follow the traditional 1031 exchange rules listed above.
Umbrella Partnership Real Estate Investment Trust (UPREIT)
The other option is to use an UPREIT to complete the conversion. This is also known as an IRC 721 exchange for the Internal Revenue Code section it is related to. With this strategy, the standard timing rules and using a qualified intermediary do not apply as they do in a 1031 exchange. In a 721 exchange, the investor exchanges their real property for operating partnership units in an umbrella partnership REIT. An UPREIT is different than a real estate investment trust (REIT) in that it only holds real estate. The REIT is a partner in the UPREIT. Using the UPREIT 721 exchange defers any gain like a 1031 exchange. The gain is deferred until the investor cashes out or converts the operating partnership units to the underlying REIT.
The downside is very little control over the investment. Also, there is more complicated federal and state tax compliance involved with the UPREIT. In addition, you cannot exchange the property again in another 1031 exchange, whereas if you had exchanged your original property for another physical property, that could be exchanged again in another 1031 exchange. Not every property is a good fit for an UPREIT. If this is a strategy you want to utilize, you will want to reach out to the REIT to see if it will take the property.
Conclusion
Deferral of gain from real estate is a powerful tax planning tool. There are several options to consider besides a standard 1031 exchange. No matter what tool you use, reach out to your tax advisor before you undertake one of these strategies or even a traditional 1031 exchange. There are numerous ways to get a deferral wrong, and you need your tax advisor to help guide you through it. If you have any questions or need assistance, please reach out to a professional at Forvis Mazars.