Can You Do a 1031 Exchange into a REIT with Section 721 Exchange?

**The information on this web page is provided for informational purposes only and should not be considered as legal, tax, financial or investment advice. Since each individual’s situation is unique, a qualified professional should be consulted before making financial decisions.**

In this article we will discuss methods of exchanging real estate property into REIT shares by using section 721 exchange with and without section 1031 tax-deferred exchange involved. We will go over the rules and benefits of these methods so that you will be able to decide which one works best for you.

 

Exchanging Real Property into REIT Shares with IRC Sections 1031 and 721


Can You Do a 1031 Exchange to REIT Shares?

Yes, but not directly. IRS 1031 exchange rules only permit exchanges of like-kind real estate property held for business or investment purposes. These exchanges can’t be made directly from real property exchange funds into securities such as Real Estate Investment Trust (REIT) shares.

An Umbrella Partnership Real Estate Investment Trust (UPREIT) uses both IRS Code Sections 1031 and 721 in a tax free exchange. In this combined transaction, with the help of qualified intermediaries [1], property owners exchange their investment properties for fractional property interests. Then, typically around 24 months later, these holdings are reinvested in REITs.

The three exchange approaches are charted below.

Real Estate to REIT Exchange Comparison

Reasons for UPREIT’s popularity today include overcoming this hurdle: most REITs have specific acquisition criteria. Investors’ relinquished properties will not often meet the criteria for those REITs that they want to invest in.

Another benefit exchanging into REITs gives you is the easier avoidance of taxable boot (discussed in more detail in our articles about partial 1031 exchanges and taking cash out of a 1031 exchange).

UPREITs’ answer involves acquiring fractional real property interests that will meet targeted REIT criteria. To be safe from IRS challenges, these fractional investments are often held for at least 24 months. Regular dividends are paid during this period. Then exchange funds are reinvested in REIT shares or units (explained later).

 

[1] Read more about what a Qualified Intermediary does for you in a 1031 exchange transaction from our article All About 1031 Exchange Facilitators (aka Accommodators or Qualified Intermediaries).

Note: the most popular kind of REIT 1031 exchange is acquiring a share in a Delaware Statutory Trust. Read more about this in our guide to Delaware Statutory Trust (DST) 1031 Exchange.

 

What Is a 721 Tax Deferred Exchange?

A section 721 exchange–real estate for REIT–participation is thriving right along with §1031 and UPREIT exchanges. Here is a definition of a 721 exchange:

A 721 exchange is a type of tax-deferred exchange that allows exchanging rental or investment property for real estate investment trust (REIT) interests. A 721 exchange allows investors to make tax free exchanges without having to find replacement properties.

In a 721 exchange investment owners contribute their real estate property to REITs in exchange for shares. Or instead of shares, units in Operating Partnerships (OPs) may initially be issued.

OPs are independent intermediaries often owned by REIT sponsors (description follows). As reflected in the chart, OP’s aggregate real estate property and exchange funds.

At the Partnership’s discretion, these assets may be retained for a time before rolling them into a REIT tax free exchange. Remember, REITs are a property to security exchange so there’s no two year property holding stipulation.

REITs are trusts that own property portfolios, e.g., office building, hotels and shopping malls. Income is derived from leasing these properties to tenants and collecting rent. They may also earn mortgage interest by lending capital to companies developing land.

REITs have many intertwining components and players. Each REIT’s Trust Deed prescribes rules of the road for its many players.

  • Unitholders are investors such as you.
  • Trustees as property owners are high-level overseers that undertake long-term financial planning, ensure compliance with legal requirements, and monitor REIT managers’ fiduciary responsibilities.
  • REIT managers are responsible for a REIT’s growth via property acquisitions and other operational and managerial decisions such as assigning property managers to the various holdings.
  • Property managers carry out the day-to-day operations of portfolio holdings.
  • Sponsors are separate entities–Operating Partnerships perhaps–also often REIT shareholders, even founders. Due to their large holdings, they are able to add bargain properties to OPs and REITs, raise credit scores, and even have REITs as subsidiaries.

All participants must play by the rules for the exchange to succeed and retain its benefits.

 

721 Exchange Rules

Now, let’s discuss how to do a section 721 exchange. While not as complex as an UPREIT, it is nonetheless daunting. Most often, professional assistance is called for.

IRS 721 allows real estate property investors to contribute their properties to REITs in exchange for REIT shares or Operating Partnership units (PO units). OP units enjoy all of a REIT’s economic benefits including distributions of operating income.

Neither of these two exchanges triggers capital-gains or depreciation recapture taxes. Later units may be converted into shares of issuing REITs.

All of the following IRS exchange rules must be observed at the risk of the exchange failing or taxes being imposed.

  • Once exercised, neither REIT shareholders nor OP unitholders may reverse the process and regain ownership of relinquished properties.
  • Even if the real estate has already been sold, investors may still contribute exchange funds for REIT shares directly or initially to OPs for units.
  • Investor unitholders do not control when their OP units are rolled into REIT shares, but this is a tax free exchange.
  • Investors may sell shares consistent with REITs’ redemption program–or if publicly traded–shares may be sold like stocks.
  • Investors retain shareholders control over the timing and quantity of any shares sales.
  • Investors may liquidate the REIT shares in accordance with REIT’s Trust Deed, selling properties much like common stocks.
  • So long as real properties remaining in the REIT–or with an OP–capital gains and depreciation recapture taxes remain deferred.
  • After receiving REIT shares or OP units, taxes cannot again be deferred in any future transactions.
  • With sales of REIT interests–with proceeds returning to investors–any capital gain or loss must be recognized.

 

Section 721 Exchange Benefits

Increasingly, IRS 721 real estate property for REIT exchanges are being deployed by investors. It’s a tool for deferring taxes, wealth growth, portfolio diversification, and estate planning.

Even after real estate has been sold, it’s not too late. Those proceeds may still be used as exchange funds contributed directly into a REIT or §721 interim Operating Partnership. Plus, replacement properties are not required.

There are more good reasons to exchange real property for REITs.

  • Investors control the timing and quantity of any REIT shares they decide to sell, thus whether taxes will be imposed. Capital gains and depreciation recapture taxes generally range from 20-40% of realized gains. Timing becomes a factor, i.e. whether to defer and reinvest exchange funds now. Or sell and report gains, perhaps when you have offsetting capital losses.
  • Steady income most often provided with REITs paying regular dividends. A diversified portfolio minimizes dependence on one asset to provide cash flow and appreciation.
  • With real estate property appreciation historically outstripping inflation, holding REIT shares are a good wealth building bet.
  • Liquidity ranks high with Investors buying and selling properties much like common stocks.
  • With fractional property investments possible, affordability also ranks high. Large capital investments are no longer required. Now as tenants in common, small investors may acquire an interest in institutional grade real estate (read more in our article ABCs of Tenants in Common (TIC) 1031 Exchanges).
  • Diversification is enhanced with REITs’ typically holding wide-ranging portfolios with many different tenants. Holdings are often in disparate locations and range widely across industries and asset classes.
  • Transparency is up there, too. Investors have access to REIT financial reports on a quarterly basis. Most REITs are subject to government regulations and oversight including compliance audits.
  • REITs are growth-orientated entities often with sponsor-aided support. Investment specialists routinely make strategic acquisitions on behalf of Operating Partnerships.
  • They’re time and stress savers with REIT property managers carrying out day-to-day operations of portfolio holdings. There’s also comfort in knowing these managers are answerable to Trustees and REIT managers all of whom have investor fiduciary responsibilities.
  • Speaking of time and stress, significant estate planning benefits are presented. On distribution, dividing up physical real property may become problematic. REIT shares divide easily–or perhaps better yet–may be held in trusts. Heirs will receive a stepped-up basis while avoiding all capital gains and depreciation recapture taxes deferred by the estate.

Of course, REITs may carry risks. As pointed out earlier, REIT shares and operating partnership units can’t be exchanged back for ownership in real estate properties. In short–unlike §1031 exchanges–investors can no longer keep exchanging properties over time. And as is always the case with investing, not all losses are foreseeable.

It’s very evident that tax issues covered here are very complex. Quite likely professional guidance will benefit most investors in optimizing benefits and mitigating risks.

 

How to Ensure Your Exchange Is Legal and Safe?

If your exchange from real estate to REIT shares must involve section 1031 exchange as a part of the procedure, it also must involve a qualified intermediary. A professional, competent, and experienced 1031 exchange company will ensure that the procedure is completed legally, in compliance with all IRS rules.

PropertyCashin is an all-in-one platform for commercial real estate investors that maintains relationships with top-rated 1031 exchange firms in all locations of the USA. To get connected with the best professionals and have your exchange processed safely and effectively, fill out the form below.

About the Author
Sam McGrath

As the Lead Commercial Real Estate Analyst at PropertyCashin, Sam McGrath is responsible for the company’s national sales strategy. Prior to his position with the company, Sam served as a Surface Warfare Officer in the United States Navy. Further, Sam was the National Recruitment Manager at Maxim where he expanded the Maxim healthcare brand nationally. He has over 8 years of experience in creative real estate investing. In addition, Sam has bought and sold commercial and residential property in over 42 states. Sam has a bachelor’s degree in business administration and marketing from Texas State University.

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