Many 1031 exchange participants who are tired of actively managing their investment properties and want to diversify* their 1031 exchange eligible equity rather than buying a single property again wonder, “Is it possible to do a 1031 exchange into a REIT?” Yes, but not directlyrather, indirectly, as part of a multi-step process.
Because REIT shares are not considered securities, an investor cannot perform a straight 1031 exchange into one “For the purposes of a 1031 exchange, the IRS considers “similar kind” property. However, under IRC Revenue Ruling 2004-86, an investor may purchase an interest in a Delaware Statutory Trust DST property via a 1031 exchange “Like-minded.”
After the investor purchases a DST interest, the DST (and the real estate in it) may be called into the REIT as part of its business plan, and the investors may use a section 721 exchange to swap their DST interests for shares of the REIT’s operating partnership on a tax-deferred basis (also known as OP Units). The OP Units are normally convertible into REIT common stock on a one-to-one basis. This strategy is not included in every DST’s business plan, and even if it is, there are no guarantees that the exit will be via a UPREIT/721 exchange.
The investor has now postponed his or her taxes by using a 1031 exchange into a DST and then a 721 exchange from the DST into the REIT. Now that this explanation has clarified the situation, “In order to answer the question “Can I 1031 Exchange into a REIT?” we need to look at certain sometimes overlooked ramifications that investors should be aware of.
Once an investor converts to a REIT under Section 721, he or she can never execute another 1031 exchange with that equity. They become taxable the moment they sell their REIT shares. As a result, all Federal Capital Gains (15-20%), State Capital Gains (0-11.3%), Depreciation Recapture Tax (25%) and Medicare Surtax (3.8%) will be due at the time of sale. Because many investors have used 1031 exchanges for many years, the final tax bill for many investors could be extremely big, and the tax bite might be significant. Many of our clients ponder whether a 1031 exchange into a REIT is a worthwhile venture after knowing this truth.
Many non-traded or private REITs are not liquid, which is something many investors should consider as they examine future possibilities for their real estate holdings/tax deferral plans, etc. An investor would have to be okay with never executing another 1031 exchange, as well as the possibility of paying taxes on the REIT shares when they are sold. Our investors have frequently determined that the risk of Non-Traded REITs, as well as their sporadic track records (although some have performed well for investors), is not worth the effort.
The following articles provide published examples of the dangers associated with investing in non-traded REITs:
Can I do a 1031 exchange into stock?
Is it Possible to Do a 1031 Exchange on Stocks? The answer to this question is, in a nutshell, no. The IRS has categorized 1031 exchanges as being utilized exclusively for real estate investments. The IRS does not regard stocks, bonds, or other types of assets to be real property.
Can you do a 1031 exchange on investment property?
The IRS has concluded that numerous types of real estate, including any property used for a business, such as a store, manufacturing plant, or office building, can be used for a 1031 exchange. Rental properties, as well as investment properties, can be used in a 1031 exchange. Water and mineral rights have even been declared to be eligible for a 1031 exchange. These are ineligible for a 1031 exchange:
In a partnership, there are many types of interests (we will discuss later a major exception to this one)
Action of a Chose (a right to something, such as payment of a debt or damages for injury, that can be recovered in a lawsuit)
Can a REIT be traded on an exchange?
Many REITs are registered with the Securities and Exchange Commission (SEC) and are traded on a stock exchange. These are known as publicly traded real estate investment trusts (REITs). Others may be registered with the Securities and Exchange Commission (SEC), but they are not publicly traded. Non-traded REITs are what they’re called (also known as non-exchange traded REITs). One of the most crucial contrasts between the various types of REITs is this. Before investing in a REIT, make sure you know if it’s publicly traded and how that can influence the benefits and dangers you face.
How does a 721 exchange work?
Similar to the 1031 exchange, the 721 exchange permits an investor to defer capital gains taxes while relinquishing control of a property used for business or investment. Both tax mitigation options are viable alternatives to a typical sale, which can result in capital gains taxes of up to 30%. (use our capital gains tax calculator to estimate yours).
By selling investment property and reinvesting the earnings in a like-kind asset, a 1031 exchange permits an investor to delay capital gains taxes.
However, for certain investors, the 1031 may not be the best option. For example, an investor may be drawn to a REIT investment because of the stable income, tax benefits, and possible gain it might bring, despite the fact that it does not meet the conditions for a 1031 exchange.
A real estate investor can defer capital gains taxes on the sale of a property by using a 721 exchange to buy REIT shares.
Can I 1031 into Fundrise?
Fundrise investments are not eligible for 1031 exchanges. A person must exchange real property for “like-kind” property under Section 1031. Section 1031 treatment does not apply to stocks or shares (such as shares of our eREITs or eFund).
Is it worth doing a 1031 exchange?
In a nutshell, the 1031 exchange is a tax-deferred exchange “The term “rollover” refers to the process of rolling over the proceeds from a sold property into a new property in order to defer capital gains tax. The property that has been purchased is often referred to as a “If it is (1) like-kind investment real estate titled in the same manner as the sold property; (2) identified within 45 days of closing the sold property and purchased within 180 days of closing the sold property; (3) of equal or greater value than the sold property and purchased using all proceeds from the sold property; and (4) purchased through a third-party exchange facilitator, it generally meets exchange requirements.
I recently assisted an investor in the sale of a 16-unit multifamily building he had owned for 30 years. The property was free and clear at the time of sale. He considered selling the property every few years over the past three decades, but was terrified of the 1031 exchange process. His stake now would be worth $4 million instead of $2 million if he had swapped and rolled it a few times.
Can you do a 1031 exchange with an LLC?
No, an LLC member interest or partnership interest is considered personal property and cannot be exchanged if the LLC elects to be handled as a partnership. The exchange of partnership interests is expressly prohibited by IRC Section 1031(a)(2)(D). However, a 1031 exchange can be done on the entity level by an LLC or partnership (or any other entity for that matter), which means the entire partnership relinquishes a property and the entire partnership continues together and obtains a replacement property. If some LLC members or partners want to exchange but others don’t, talk to your tax or legal counsel about the challenges involved with tactics and the timing of “drop and swap” or “swap and drop” options. A husband and wife who are the sole members of a two-member LLC may be considered a single-member disregarded LLC for Federal tax purposes in community property states only consult your tax or legal professionals for further information. Partnerships and 1031 Exchanges is the complete article.
How do I set up a 1031 exchange?
Are you perplexed yet? Completing a successful and IRS-compliant 1031 exchange entails a lot of work. Here’s a consolidated list of the general steps of a conventional (delayed) 1031 exchange to try to make things a little easier for you:
- To make the transaction go more smoothly, hire a qualified intermediary (QI). This should be done before you try to sell the original property.
- Any offer you receive should include a relinquished property addendum. This allows you to assign the contract to your QI while also indicating that you plan to do a 1031 exchange with this property.
- You have 45 days after the sale of the original home has closed to find three possible replacement properties. Send a letter to your QI with specifics about each one once you’ve completed this.
- Send a copy of your purchase contract to the QI once you’ve determined the property or properties you want to buy and have an executed contract.
- Sign a contract for the new property’s assignment. This stage should be guided by your QI.
- Within 180 days of the sale of the original property, close on the new property.
- With your tax return, file IRS form 8824 to disclose the 1031 exchange. Regardless of when the 1031 exchange is completed, do this for the tax year in which the original property was sold. For this phase, I strongly advise consulting a tax professional.
Does 1031 apply to primary residence?
A 1031 exchange, often known as a “like-kind exchange,” allows real estate investors to postpone paying taxes on the sale of a rental property.
You can avoid paying capital gains and depreciation recapture tax on a sale if you sell one investment property and use the money to buy another. Of fact, it’s more complicated than that; for additional information, see our guide to 1031 exchanges. But that’s the gist of it.
In most cases, a 1031 exchange only involves investment properties. A 1031 exchange isn’t usually possible with your principal residence. If you don’t regard it as an investment property for tax reasons, even a second house that you live in part of the time is ineligible.
How long must you hold 1031 property?
The IRS recognizes that a person’s circumstances may change over time, thus a property’s character may vary as well. As a result, it is conceivable for an investment home to become a primary dwelling in the future. If a property is purchased through a 1031 Exchange and then turned into a primary residence, it must be held for at least five years before the sale becomes completely taxed.
The Universal Exclusion (Section 121) permits a person to sell his home and earn a tax exemption on the first $250,000 of the gain, or $500,000 if married. To qualify for this benefit, the investor must have lived in the property for at least two of the previous five years.
The property obtained as an investment through an exchange can be sold using the Universal Exclusion after it has been converted to a primary residence and all of the criteria have been met. This method has the potential to virtually eliminate a taxpayer’s tax liability, making it a fantastic end game for investors.
Can you live in a 1031 exchange property after 2 years?
Gain on the sale of a personal house is tax-free up to $500,000 for married taxpayers filing a joint return ($250,000 for single taxpayers) provided the taxpayer has owned and lived in the residence for two years out of the previous five years, according to IRC 121.
Taxpayers have long known that they could cash out of rental properties “tax-free” under the rules of IRC 121 related to the tax-free sale of a personal dwelling, subject to exclusions (see below) (the Section 121 exclusion). They only had to relocate into a rental property, live there for two years, and then sell it as a personal residence “tax-free.” It is not taxable to convert a rental property to a personal dwelling.
What if the rental home is unsuitable for a taxpayer to live in for the next two years? A 1031 Exchange for a property that will be suited for the taxpayer is the answer. Astute real estate investors are also aware that they can use a 1031 Exchange to roll out an investment property and replace it with a qualifying residential real estate investment property. They then rent it out for a year or so (at least one year is recommended by exchange professionals) before moving in. They can use the Section 121 exclusion on a later sale if they have lived in it for two years or more (and have owned it for five years).
With the American Jobs Creation Act of 2004, the five-year ownership requirement went into force on October 22, 2004. For property obtained as replacement property in a 1031 Exchange, the Act imposed a new five-year ownership requirement. The residence requirement of two years has not changed.
Even if the home otherwise qualifies for the Section 121 exclusion, any depreciation incurred after May 6, 1997 is not eligible for the Section 121 exclusion and must be declared as income. This exception applies to rental houses that have been converted to personal residences, as well as any depreciated portion of a personal residence (i.e. home office).
Prior to May 6, 1997, any depreciation incurred on the residence does not count and is not taxed under 121. This regulation is beneficial for rental homes that were heavily depreciated prior to 1997 and were then converted to a personal residence.
It’s worth noting that this “depreciation recapture” regulation only applies to depreciation on the home that’s being sold, not to depreciation on a rental property that was exchanged for a new home under IRC Section 1031. For the purposes of this “depreciation recapture” provision under IRC 121, depreciation taken on a previous rental property does not roll over to the replacement house.
The benefits of the Section 121 deduction on the sale of a personal dwelling were limited by the Housing Assistance Tax Act of 2008. In a word, any “disqualified usage” of a residence after January 1, 2009 disqualifies a portion of the 121 gain from being exempt. As a result, any rental use of the residence after January 1, 2009 is “non qualifying use,” and any exclusion under IRC 121 must be prorated to calculate the portion of the gain not eligible for the 121 Exclusion.
This new regulation applies to rental properties converted to personal residences after May 1, 2009, and it is ineffective for converting an investment property to a personal residence for the purpose of qualifying the house for a subsequent sale eligible for the Section 121 exception.
