A 1031 exchange is a wonderful way to defer taxes for property owners. But what if you don’t want to manage your real estate investments actively anymore?
Can you 1031 exchange to REIT instead?
Read on to find out.
About REITs
A real estate investment trust owns, finances, or operates income-generating properties. It pools investor money, just like a mutual fund, but uses it for real estate opportunities.
REITs are traded just like securities on the stock market, but they have special regulations which set them apart from other corporations.
They are mandated to return at least 90% of their net taxable incomes back to investors in the form of dividend distributions.
As a result, their dividend yields are usually higher than stocks.
How Do REITs Avoid Taxes?
REITs do not pay corporate taxes on most income they pass on to unitholders, and the holders, in turn, receive tax deductions on a part of the income they receive.
The special provisions that require REITs to return 90% of their income from operations to their unitholders also specify that they do not get taxed for it as long as they meet certain criteria.
The government treats this income as “pass through” (collected and paid forward) and exempts it from corporate taxes.
From a unitholder’s standpoint, the dividend income from REITs gets divided into three categories:
- Return of capital
- Capital gains
- Normal income
Return of capital is completely non-taxable.
Capital gains are taxed as per the long-term capital gains tax rate eligible for the unitholders.
Lastly, a part of the normal income is eligible under the Tax Cuts and Jobs Act for preferential tax treatment.
The act allows a 20% deduction of pass-through income (which includes qualified REIT income) from your taxable income.
Hence, both the trust and the unitholders receive several advantages in taxation through the REIT structure.
What Types of REITs Are There?
There are three types of REITs: Equity, mortgage, and hybrid.
Equity REITs own and operate income-generating properties. They may buy and run corporate offices, rental properties, hospitals, retail spaces, and so on.
Equity REITs also make money from the lease rentals on these properties.
Mortgage REITs (mREITs) create mortgages and buy/sell mortgage-backed securities. These mortgages help buyers acquire real estate that would normally be beyond their means.
mREITs generate income through the difference between the rates at which they offer mortgages and the interest rates at which they source funds.
Hybrid REITs are just as they sound: they are a combination of equity and mortgage REITs.
Now that you know more about REITs, let’s take a look at 1031 exchanges.
About 1031 Exchanges
A 1031 exchange involves exchanging a real estate investment property with a suitable replacement property, letting the owner defer the capital gains tax from the sale.
An exchange of this type can only be made between “like-kind” properties, i.e., real estate held for business, trade, or investment, and Delaware Statutory Trusts (more on this later)
Personal residences cannot be swapped under a 1031 exchange (Except for very specific cases). Moreover, there are strict regulations regarding their use for vacation properties.
How Many Times Can You Do a 1031 Exchange?
There is no limit on the number of times real estate investors can do a 1031 exchange.
If executed correctly, 1031 exchanges can let investors continually swap their business or investment real estate properties for decades.
Normally, each such swap would invite a capital gains tax, but in a 1031 exchange, no tax is applicable as long as the sale follows all the rules laid out by the IRS.
How Do I Avoid Capital Gains Tax on a 1031 Exchange?
Under a 1031 exchange, when the owner of an investment property sells it and uses the proceeds to buy a new one, they do not have to pay capital gains taxes.
There are a few caveats, however. Firstly, the time frame between selling the old property and buying the new one has to be less than 45 days.
Something else to consider is that the new property must be of equal or greater value.
Also, both have to be like-kind (as explained earlier). Lastly, the proceeds of the sale should be held by a qualified intermediary instead of reaching the pockets of the seller.
The main benefit of doing this is that with lesser taxes to pay, the buyer has more money to reinvest in the new property.
Moreover, eventually, when the property owner decides to sell in cash, they only have to pay the long-term capital gains tax on the final transaction.
At that time, the tax rate applicable will depend on their net taxable income when the sale happens.
Can You 1031 Exchange To REIT?
No, a REIT is not eligible for a 1031 exchange because the IRS does not view it as “real property” (it is only viewed as a personal asset).
Many investors might be tired of actively managing their real estate or might be looking to lower their risk by entering into REIT shares.
However, they cannot use the 1031 exchange rules to avoid capital gains taxes by exchanging their property with REITs.
There is a workaround to this using Delaware Statutory Trusts. We will cover it in later sections.
What Are Delaware Statutory Trusts (DSTs)?
A Delaware Statutory Trust (DST) is a REIT-like legal entity that can hold title to multiple income-producing properties at once.
DSTs offer several tax advantages, provide good returns, and, most importantly, they are eligible as a like-kind property under the 1031 exchange rules.
DSTs were first created in 1988 under Delaware state law. Their offerings can have any commercial real estate, such as office buildings, apartments, parks, and other properties.
How Does a Delaware Statutory Trust Work?
A DST is a property ownership structure with several investors, each of whom owns a part of the trust.
Every DST starts out with a sponsor, which is a professional real estate company that helps identify and buy properties for it.
As investors keep joining the trust, their money starts to replace the initial capital investment of the sponsor until all the assets are owned directly by the investors.
Each investor owns some fraction of every asset held by the trust — no one person can fully claim to own any of the assets.
This is known as a fractional ownership structure or fractional interest.
Also, fractional interest through a DST receives the same treatment in taxation as owning property directly.
This is why DSTs are treated as real properties under the 1031 exchange rules.
Is a Delaware Statutory Trust a Legal Entity?
Yes, a Delaware statutory trust is an independent legal entity. It was created under the Delaware Statutory Trust Act (the DSTA).
The act gave a lot of freedom to DSTs in terms of the purpose for which they are made, their operation, and their governance.
Who Can Set up a Delaware Statutory Trust?
To start a Delaware statutory trust, a certificate of trust needs to be filed with the Delaware Division of Corporations.
It must include the trust’s name and at least one trustee registered in Delaware, apart from other information.
The trustee can be a corporation of another trust company as long as they are based in the State of Delaware.
How To Do a 1031 Exchange Into a REIT Using DSTs
Some DSTs intend to convert into REITs as part of their business plan.
An investor can convert their DST interest into Operating Partnership units (OP units) of the REIT using a 721 exchange, with the benefit of tax deferment still intact.
OP units offer a right to receive cash flow from REITs and, in the long term, are convertible one-for-one into REIT shares.
So finally, the investor’s exchange funds end up as REIT shares with the same tax benefits. This process can take several years.
There are pitfalls to this approach, however.
The REIT share can never be converted back to a 1031 exchange.
Moreover, any future sale of the REIT would immediately require payment of any accumulated capital gains taxes (both federal and state) and depreciation recapture tax.
If the investors have been doing 1031 exchanges for a long time, these immediate tax liabilities would be colossal.
Hence, it is an approach that could end up causing more harm than good.
How Safe Are Delaware Statutory Trusts?
Delaware statutory trusts are real estate-driven. Therefore, they are susceptible to all the risks of their underlying real estate, including illiquidity and interest rate risks.
Moreover, as we explained earlier, converting a 1031 exchange into a REIT using DSTs may invite heavy taxation, especially if the exchange has been going on for a long time.
Lastly, DSTs are complex instruments that need real estate professionals to handle them. Managing a 1031 exchange using DSTs takes a lot of planning.
What Are the Disadvantages of a DST?
DSTs require you to be an accredited investor, can be illiquid, and need cautious handling to avoid penalties. They also carry all disadvantages of owning actual real estate, such as interest rate risk.
DSTs, just like REITs, lead to a loss of control.
Coming from a 1031 exchange after owning property is a different experience. There is a lot of decision-making power in owning property.
DSTs are entirely different, and the investor might feel a loss of control when dealing with them. For some, this could be a bitter pill, while others might see this as a benefit.
DSTs can be illiquid
Owning a DST is not like having a stock. It is a long-term commitment where the time required for maturity may be anywhere between five and ten years or more.
Another drawback is that only accredited investors are eligible for DSTs
Accredited investors are ones whose incomes are > $200,000 (or joint incomes are > $300,000). Individuals with $1 million or higher net worth are also eligible.
If the investor does not meet these requirements, they are not applicable for DSTs
A 1031 exchange through a DST is hard to execute.
As per regulations, a 1031 execution needs to be done within 45 days of the sale of the first property.
Given the short timeframe and complex handling, it requires expert professionals to execute it. A poorly executed move can end up with an unfavorable tax ruling and derail the entire process.
What Is the Average Return on a Delaware Statutory Trust?
The return on a DST depends on the portfolio of properties it owns.
Low-risk DSTs which hold multifamily apartments tend to return 4-6% yield, whereas those who have higher-risk industrial property might give up to 6-9% yields.
DSTs with holdings in high-income areas that have stable occupancies often give lower yields, whereas those in rural areas or new cities tend to give higher ones.
Moreover, just like a REIT investment, DSTs also offer capital appreciation, and many investors find that the growth in value is usually a higher component of the absolute returns.
Is a Delaware Statutory Trust a Good Idea?
Delaware Statutory Trusts offer benefits such as good monthly yields, capital appreciation, and the ability to make a 1031 exchange into a managed property.
On the other hand, they have a few problems, such as low liquidity, loss of control, difficulty of execution, and almost no option to exit in the short term.
Overall, if your investment objectives are to put your money in a long-term asset that can generate passive income as well as grow your money, DSTs might be a good idea.
Conversely, if you are an active investor who wants to grow wealth by trading regularly, stocks or REITs might be a better option
There is, of course, a way to convert your 1031 exchange into REITs, but it is quite complex and can lead to bigger tax liabilities
Final Thoughts
DSTs might offer a way to move your 1031 exchange into a REIT, but it is an arduous and complex process that may end up costing a bigger tax liability later on.
Instead, you might consider 1031 exchanging to a DST itself, but they are not without their fair share of problems and are quite illiquid compared to REITs.
Whether a DST is the right option for you depends on your investment objectives and how long you are willing to wait for your returns.