Can a REIT Be Used for a 1031 Exchange?

Real estate investors seek strategies to defer capital gains taxes when selling investment properties. The 1031 exchange allows for tax deferral if proceeds are reinvested into “like-kind” property. A common question concerns the eligibility of Real Estate Investment Trusts (REITs) within this framework. While publicly traded REIT shares are considered securities and not direct real estate, certain REIT-like structures, particularly Delaware Statutory Trusts (DSTs), can qualify for 1031 exchanges, offering investors a way to maintain tax-deferred status while transitioning real estate holdings.

Understanding the Basics of 1031 Exchanges

A 1031 exchange, under Section 1031 of the U.S. Internal Revenue Code, allows investors to postpone capital gains tax on investment property sales. Deferral occurs when proceeds are reinvested in “like-kind” property, defined as real property held for investment or productive use in a trade or business. This provision allows investors to build wealth through real estate without immediate capital gains taxes.

The “like-kind” requirement is broad for real estate, allowing any real estate held for investment or business purposes to be exchanged for another. For example, an apartment building can be exchanged for vacant land, or a commercial property for an industrial building. Personal residences or properties held primarily for resale do not qualify for this tax treatment. To facilitate a deferred exchange, a Qualified Intermediary (QI) is involved to hold the sale proceeds, preventing constructive receipt of funds, which would trigger immediate taxation.

Understanding REIT Structures and Real Estate Ownership

A Real Estate Investment Trust (REIT) operates as a company that owns and operates income-producing real estate. They allow investors to earn income from real estate without direct purchasing, managing, or financing. REITs can own various property types, including office buildings, shopping centers, apartments, and warehouses.

REITs are categorized based on how they are traded: publicly traded, publicly registered but non-listed, or private. Publicly traded REITs are bought and sold as shares on major stock exchanges, similar to corporate stocks. An investment in a publicly traded REIT constitutes an equity interest in a company, making the shares securities, not direct real property. In contrast, Delaware Statutory Trusts (DSTs) are designed to allow investors to hold a direct, undivided beneficial interest in real property. This distinction in ownership is fundamental to determining eligibility for a 1031 exchange.

Eligibility of Specific REIT Structures for 1031 Exchanges

The qualification of a real estate investment for a 1031 exchange hinges on whether the investor owns a direct interest in real property, rather than shares in an entity that owns property. Publicly traded REIT shares are considered securities, not real property, and therefore do not qualify as “like-kind” property for a 1031 exchange. An exchange of publicly traded REIT shares is a taxable event, as it involves the sale of a security, not a direct real estate exchange.

Delaware Statutory Trusts (DSTs) are a notable exception and are widely used in 1031 exchanges. The IRS’s Revenue Ruling 2004-86 clarified that a beneficial interest in a properly structured DST can qualify as “like-kind” property for a 1031 exchange. This ruling treats the beneficial interest in the DST as direct ownership of the underlying real property for federal income tax purposes, allowing tax deferral. To maintain this tax classification, a DST must adhere to specific IRS restrictions, often called the “seven deadly sins,” which ensure it functions as a passive investment trust by limiting the trustee’s ability to vary the investment, acquire new property, or renegotiate leases. This structure provides a pathway for investors to move from actively managed real estate to a passive, professionally managed asset while continuing to defer taxes.

Practical Steps for a 1031 Exchange Involving Eligible REIT Structures

A 1031 exchange involving an eligible REIT structure, like a Delaware Statutory Trust (DST), requires careful adherence to IRS regulations. The process begins with the sale of the relinquished property, with proceeds immediately transferred to a Qualified Intermediary (QI). The QI holds these funds to prevent constructive receipt, which would invalidate tax deferral.

Following the sale, the investor faces strict timelines: a 45-day identification period and a 180-day exchange period. Within 45 days of closing the relinquished property, the investor must identify potential replacement properties, including interests in one or more DSTs. The entire exchange, including DST interest acquisition, must be completed within 180 days from the relinquished property sale. Due diligence when selecting a DST is important; investors should evaluate the sponsor’s experience, underlying real estate assets, and financial projections outlined in the Private Placement Memorandum. Consulting with tax advisors and legal professionals experienced in 1031 exchanges and real estate syndications is advisable to navigate complexities and ensure compliance.