Can You Do a 1031 Exchange Into a REIT?

A 1031 exchange offers real estate investors a strategy to defer capital gains taxes when selling an investment property, provided the proceeds are reinvested into a “like-kind” replacement property. A common question arises regarding whether a 1031 exchange can be directly executed into a Real Estate Investment Trust (REIT). While direct investment into publicly traded REIT shares generally does not qualify for this tax deferral, specific structures exist that enable investors to align with 1031 exchange requirements, such as Delaware Statutory Trusts (DSTs). This approach allows investors to access professionally managed real estate portfolios while still deferring capital gains.

Understanding 1031 Exchanges and REITs

A 1031 exchange, rooted in Section 1031 of the Internal Revenue Code, allows investors to defer capital gains taxes on the sale of investment property by reinvesting the proceeds into another qualifying property. This tax-deferral mechanism helps preserve capital for continued investment in real estate. The fundamental condition for such an exchange is that the relinquished property and the replacement property must be “like-kind,” meaning they are similar in nature or character.

A Real Estate Investment Trust (REIT) is a corporation that owns, operates, or finances income-producing real estate. REITs enable individuals to invest in large-scale real estate portfolios, similar to how mutual funds allow investment in diversified stock portfolios. Many REITs trade on major stock exchanges, offering liquidity and diversification to investors.

Despite REITs primarily holding real estate assets, directly investing in the shares of a publicly traded REIT typically does not qualify for a 1031 exchange. The Internal Revenue Service (IRS) views shares of stock as personal property, which does not meet the “like-kind” requirement for real estate exchanges.

The Like-Kind Property Requirement

For a 1031 exchange to qualify, the exchanged properties must be real property held for investment or productive use in a trade or business. The IRS broadly interprets “like-kind” to mean real estate for real estate, regardless of its grade or quality. For example, an apartment building can be exchanged for raw land, or a ranch for a retail center, as both are considered real property.

A crucial distinction exists between real property and personal property. Real property includes land and anything permanently attached to it, such as buildings and structures. Conversely, personal property refers to movable items. The IRS explicitly states that stocks, bonds, notes, and other securities are considered personal property.

Even though a REIT’s underlying assets are real estate, the shares themselves are considered equity interests, which are personal property. This means exchanging real estate for REIT shares does not satisfy the “like-kind” requirement.

Delaware Statutory Trusts (DSTs) as a Solution

Delaware Statutory Trusts (DSTs) offer a compliant method for investors to engage in a 1031 exchange involving passive real estate. A DST is a legal entity that holds title to real estate, allowing multiple investors to acquire fractional ownership interests in large-scale properties. These interests are structured to be treated as direct ownership of real property for 1031 exchange purposes.

The qualification of DSTs for 1031 exchanges is supported by IRS Revenue Ruling 2004-86. This ruling established that beneficial interests in a DST can be considered “like-kind” to real property, provided the DST adheres to certain conditions. These conditions restrict the trustee’s powers, ensuring the DST functions as a passive holding vehicle for real estate. For instance, the DST cannot accept new capital contributions after its offering closes, nor can the trustee renegotiate existing loans or enter into new leases, except under specific circumstances like tenant bankruptcy.

DSTs address several challenges faced by investors in 1031 exchanges. They offer passive ownership, eliminating the responsibilities of property management, tenant issues, and maintenance, which are handled by professional management companies. DSTs also allow for diversification across multiple properties and geographic locations, and provide access to institutional-grade assets that might otherwise be beyond an individual investor’s reach. While DST investments are typically illiquid, they provide a structured pathway to defer capital gains when transitioning from actively managed properties.

Executing a 1031 Exchange with a DST

Executing a 1031 exchange with a DST involves specific procedural steps and strict timelines. A Qualified Intermediary (QI) is a key party in this process, facilitating the exchange by holding funds from the relinquished property and ensuring compliance with IRS regulations. The QI prevents the investor from having constructive receipt of the sale proceeds, which would disqualify the exchange.

After selling the relinquished property, the investor has a strict 45-day identification period to formally identify potential replacement properties. DSTs can be identified during this period, and their pre-packaged nature can help investors meet this deadline more efficiently.

Following the identification period, the investor has a 180-day exchange period to complete the acquisition of the identified replacement property, or the DST interest. Both the 45-day identification period and the 180-day exchange period run concurrently and are strictly enforced by the IRS. The process involves selecting a suitable DST offering, evaluating its property, sponsor, and financial projections.

Upon selection, funds held by the QI are transferred to the DST sponsor to complete the acquisition of the DST interest. After the exchange is finalized, the investor assumes a passive ownership role, receiving distributions and benefiting from the deferred tax treatment. While DSTs provide a pathway for 1031 exchanges, they do not offer immediate liquidity, and thorough due diligence on the DST sponsor and property is necessary.