Can You 1031 Exchange Into a Qualifying REIT?

A 1031 exchange offers a tax planning tool for real estate investors. This provision, found in Section 1031 of the Internal Revenue Code, allows investors to defer capital gains taxes when selling an investment property, provided they reinvest the proceeds into another qualifying “like-kind” property. Real Estate Investment Trusts (REITs) are companies that own, operate, or finance income-producing real estate, structured to provide investors with access to real estate portfolios without direct property management responsibilities. They offer regular income streams and potential capital appreciation through diversified real estate holdings. The ability to combine the tax deferral benefits of a 1031 exchange with the passive investment structure of a REIT raises an important question for many investors.

Understanding Like-Kind Property for a 1031 Exchange

For a transaction to qualify as a 1031 exchange, the properties involved must be “like-kind.” The Internal Revenue Service (IRS) defines this term as referring to the nature or character of the property, not its grade or quality. For example, an investor can exchange raw land for an apartment building, or an industrial property for a retail center, as long as both are held for productive use in a trade or business or for investment purposes. The primary residence of a taxpayer does not qualify for this type of exchange.

The Tax Cuts and Jobs Act of 2017 significantly narrowed the scope of like-kind exchanges, limiting them exclusively to real property. Previously, personal property could also qualify, but this is no longer the case. To be considered like-kind, both the relinquished property (the one being sold) and the replacement property (the one being acquired) must be real property located within the United States. Exchanging a property in the U.S. for one outside the U.S. does not meet the like-kind requirement.

While direct ownership of physical real estate qualifies, the “like-kind” requirement can also extend to certain interests in real estate. This includes fractional ownership interests in certain real property structures. The interest must represent a direct ownership stake in the underlying real estate, rather than an interest in an entity that owns the real estate. This distinction is crucial for understanding how certain investment vehicles might fit within 1031 exchange rules.

Qualifying REIT Structures for 1031 Exchanges

Investors seeking to use a 1031 exchange to acquire a passive real estate investment often consider specific structures that are treated as direct real estate ownership for tax purposes. Delaware Statutory Trusts (DSTs) are a primary example of such a structure. A DST is a legal entity formed under Delaware law that allows multiple investors to own a fractional, undivided beneficial interest in a single or multiple income-producing properties. This structure enables investors to participate in larger, institutional-grade real estate assets.

The qualification of DSTs for 1031 exchanges stems from IRS Revenue Ruling 2004-86. This ruling determined that a beneficial interest in a properly structured DST could be considered a direct interest in real estate, thereby qualifying as like-kind replacement property. For a DST to maintain this classification, the trustee’s powers must be limited, ensuring that the trust behaves more like a passive co-ownership arrangement rather than an active business entity. This includes restrictions on the trustee’s ability to dispose of property, acquire new property, or renegotiate leases, except under specific circumstances.

In contrast, traditional Real Estate Investment Trusts (REITs), particularly those publicly traded on stock exchanges, generally do not qualify as like-kind property for a 1031 exchange. This is because shares in a publicly traded REIT are typically considered stock or securities, which represent an ownership interest in the company itself, not a direct ownership interest in the underlying real estate. Therefore, exchanging real property for shares in a publicly traded REIT would typically be a taxable event, as it does not meet the like-kind requirement for real property.

Investing in a DST can offer several benefits, including passive income generation, potential for portfolio diversification across various property types, and relief from direct property management responsibilities. However, investors should be aware that DST interests are generally less liquid than publicly traded REIT shares, and they involve various fees. While DSTs offer a pathway for 1031 exchange deferral, understanding their specific structure and limitations is important for making informed investment decisions.

Executing a 1031 Exchange into a Qualifying REIT

Successfully executing a 1031 exchange, especially when acquiring an interest in a Delaware Statutory Trust (DST), requires strict adherence to specific timelines and regulations. A Qualified Intermediary (QI), also known as an exchange accommodator, is a key component of this process. The QI is a neutral third party responsible for facilitating the exchange by holding the proceeds from the sale of the relinquished property. This prevents the taxpayer from having actual or constructive receipt of the funds, which would otherwise make the transaction taxable.

The QI must be engaged before the closing of the relinquished property. They prepare the necessary exchange documents, including the exchange agreement and assignments of the purchase and sale contracts for both the relinquished and replacement properties. This documentation formally structures the transaction as a 1031 exchange, ensuring compliance with IRS regulations. The seller of the relinquished property and the buyer of the replacement property must be notified that the transaction involves a 1031 exchange, though they typically have no additional risk.

Two timeframes govern a deferred 1031 exchange. First, within 45 calendar days of the closing of the relinquished property, the investor must formally identify potential replacement properties in writing. This identification must be unambiguous, typically including a street address or legal description. For DSTs, a distinguishable name is often sufficient. Investors can identify properties using one of three rules:
The Three-Property Rule: up to three properties of any value.
The 200% Rule: any number of properties whose combined fair market value does not exceed 200% of the relinquished property’s value.
The 95% Rule: any number of properties, provided at least 95% of the identified value is acquired.

Second, the entire exchange must be completed within 180 calendar days from the closing date of the relinquished property, or by the due date of the investor’s tax return for that year, whichever comes first. This means the acquisition of the replacement property, such as the DST interest, must close within this period. To achieve full tax deferral, the value of the replacement property acquired must be equal to or greater than the value of the relinquished property, and all equity from the sale must be reinvested. If less value is acquired or some cash is received, that portion, known as “boot,” may become taxable.

Failure to adhere to these timelines or rules can lead to the disqualification of the exchange. If a 1031 exchange fails, the capital gains and depreciation recapture that were intended to be deferred become immediately taxable in the year the relinquished property was sold. This can result in significant tax liabilities, including federal and state capital gains taxes and potential penalties. Careful planning, clear communication with the QI, and diligent tracking of deadlines are essential for a successful 1031 exchange into a qualifying structure.