1031 into upREIT

[Pete Harper]

 We did a 1031 exchange into a 10 unit apartment building.  The property is underperforming the other properties in our 40 unit portfolio.  We've been consolidating our properties closer to our home location.  This is the furthest property so we can't give it the attention it needs.    One of the options we are considering is selling and rolling the equity into a upREIT.  I read were there is an option under 1031-271.  I wanted to confirm my understanding is correct.  We can use 1031-271 to reinvest equity from a 1031 property into an upREIT while maintaining tax deferral. 

[Conner Jackson]

@Pete Harper - a 721 UPREIT is essentially converting your interest in a property into operating units of a REIT. One of the easier ways to do this would be to 1031 exchange into a DST where the sponsor owns a REIT and utilizes the 721 as part of their strategy. Once you convert to operating units in the REIT you can't 1031 exchange anymore, but you may have the ability to sell your interest in small amounts to pay capital gains tax over time. Feel free to PM me if you want to discuss further!

[Jackson Hanssen]

@Pete Harper

A 721 exchange is the end of the line. Once you're into the REIT you're either going to pay taxes or die and get the step-up basis. So it really limits your flexibility. If you're still fine holding the assets directly, why not just 1031 the underperforming property back into other assets closer to home?

[Pete Harper]

Quote from @Jackson Hanssen:

@Pete Harper

A 721 exchange is the end of the line. Once you're into the REIT you're either going to pay taxes or die and get the step-up basis. So it really limits your flexibility. If you're still fine holding the assets directly, why not just 1031 the underperforming property back into other assets closer to home?

We do not anticipate having to tap the equity in the future.  The goal is estate planning where our children would enjoy the step-up basis.

We are in a very rural area.  I'm already the #3 owner in the county.  We've pretty well saturated the local market.  We are forced to invest elsewhere. 

[Jon Taylor]

@Pete Harper - Here is a forum that has discussed this topic years back: https://www.biggerpockets.com/forums/104/topics/1044333-pure...

[Jon Taylor]

@Pete Harper - 

Section 721 of the Internal Revenue Code allows an investor to exchange property held for investment or business purposes for shares in a Real Estate Investment Trust (REIT) without triggering a taxable event. The transaction allows investors to increase the liquidity and diversification of their real estate investments while deferring costly capital gains and depreciation recapture taxes that may result from the sale of a property.

Benefits:

REITs also can provide the same ongoing benefits of real estate ownership including income, depreciation tax shelter, principal pay down, and appreciation. Many REITs continue to make acquisitions on an ongoing basis. This allows the investor to benefit from future buying opportunities in the REIT without triggering any capital gains or depreciation recapture tax events. *Please note: As Dave mentioned, not all REITs allow for ongoing depreciation, but some do. It's important to understand the difference, and I'd recommend sticking with the REIT with depreciation advantages.

The Tax Cut and Jobs Act (TCJA) includes a 199A deduction and applies to certain income from pass-through entities (including REIT dividends) and allows individuals to take the 20% deduction against REIT dividend distributions that yields an effective tax rate of 29.6% or 37% (80% for upper bracket filers). But the 199A is scheduled to sunset in 2025 under the TCJA unless made permanent.

It wouldn't be uncommon for some investors to only realize taxable income on 40-50% of their dividend distributions in today's current environment (I have seen this personally).

You asked about fees, so one quick comment. Often times the transaction between the DST and the REIT involve a significantly lower commission for the brokers. As such, many aren't incentivized to advise you along that path (sad but true). Instead, the commission is passed along to the investor in the form of increased equity.

Most of the time, the REIT has liquidity as an option. This is great of your accountant who may choose to advise that you liquidate shares during a tax year where you realize some loss elsewhere. It's also a great way to pass buildings down to your kids who want nothing to do with the active management business. Instead of saddling them with a $5M commercial property (for instance), you can turn that into 166k shares and divide them amongst your kids (who are in line to get a full step-up in basis when you pass away).

Gotchas:

The UPREIT is sometimes an option, and sometimes a mandate. It's really important to understand the difference. There are examples of DSTs that included an exit into a REIT that DID NOT ALLOW the investor to do a 1031 exchange. The investor was unaware of this previously. Horrible.

The REIT is essentially a "blind pool" investment. The Trustee of the REIT can buy and sell properties within the REIT without triggering a capital gain event to you as the investor, however, this flexibility also allows the operators to potentially add properties to your investment portfolio that may expose you to risks or asset classes you were previously unaware of.

There are a couple of sponsors I am aware of that carve individual properties out of the REIT, into a DST, then pull them back into the REIT at a significant mark-up to the DST investor. This is important to understand on the front end when you are investing in the DST.

Summary:

If you are making an investment into a DST with a REIT exit, you are aligning yourself with the sponsor in a long-term way. It's more important than ever to understand what you are getting yourself into. I'd encourage you to evaluate the REIT first, then the DST second. And in some ways, the DST becomes less (*slightly less*) important in that scenario. It's a gateway into the investment you actually want to make.

I'd recommend you put yourself in a position to take advantage of a REIT exit as an OPTION, not an OBLIGATION. Test the waters with the sponsor for 3-5 years as they hold the properties in the DST, then decide if you want to align with them as a part of your long estate plan.

Last (and best) recommendation: Ask your broker what the funds from operations (FFO) ratio is. All REITs are required to show their FFO calculations on their public financial statements. The FFO figure is typically disclosed in the footnotes for the income statement. If the FOO ratio is less than 100%, hard pass. That means they are paying dividends out of investor capital or debt, instead of NOI. That easy question to answer will be a really great litmus test in your due diligence toolbox.

If you are evaluating a REIT, it would be wise and prudent to do your homework and select the appropriate professional to guide you. It can be a wonderful tool.

[Dave Foster]

Spot on @Jon Taylor!

[Pete Harper]

Quote from @Jon Taylor:

@Pete Harper - 

Section 721 of the Internal Revenue Code allows an investor to exchange property held for investment or business purposes for shares in a Real Estate Investment Trust (REIT) without triggering a taxable event. The transaction allows investors to increase the liquidity and diversification of their real estate investments while deferring costly capital gains and depreciation recapture taxes that may result from the sale of a property.

Benefits:

REITs also can provide the same ongoing benefits of real estate ownership including income, depreciation tax shelter, principal pay down, and appreciation. Many REITs continue to make acquisitions on an ongoing basis. This allows the investor to benefit from future buying opportunities in the REIT without triggering any capital gains or depreciation recapture tax events. *Please note: As Dave mentioned, not all REITs allow for ongoing depreciation, but some do. It's important to understand the difference, and I'd recommend sticking with the REIT with depreciation advantages.

The Tax Cut and Jobs Act (TCJA) includes a 199A deduction and applies to certain income from pass-through entities (including REIT dividends) and allows individuals to take the 20% deduction against REIT dividend distributions that yields an effective tax rate of 29.6% or 37% (80% for upper bracket filers). But the 199A is scheduled to sunset in 2025 under the TCJA unless made permanent.

It wouldn't be uncommon for some investors to only realize taxable income on 40-50% of their dividend distributions in today's current environment (I have seen this personally).

You asked about fees, so one quick comment. Often times the transaction between the DST and the REIT involve a significantly lower commission for the brokers. As such, many aren't incentivized to advise you along that path (sad but true). Instead, the commission is passed along to the investor in the form of increased equity.

Most of the time, the REIT has liquidity as an option. This is great of your accountant who may choose to advise that you liquidate shares during a tax year where you realize some loss elsewhere. It's also a great way to pass buildings down to your kids who want nothing to do with the active management business. Instead of saddling them with a $5M commercial property (for instance), you can turn that into 166k shares and divide them amongst your kids (who are in line to get a full step-up in basis when you pass away).

Gotchas:

The UPREIT is sometimes an option, and sometimes a mandate. It's really important to understand the difference. There are examples of DSTs that included an exit into a REIT that DID NOT ALLOW the investor to do a 1031 exchange. The investor was unaware of this previously. Horrible.

The REIT is essentially a "blind pool" investment. The Trustee of the REIT can buy and sell properties within the REIT without triggering a capital gain event to you as the investor, however, this flexibility also allows the operators to potentially add properties to your investment portfolio that may expose you to risks or asset classes you were previously unaware of.

There are a couple of sponsors I am aware of that carve individual properties out of the REIT, into a DST, then pull them back into the REIT at a significant mark-up to the DST investor. This is important to understand on the front end when you are investing in the DST.

Summary:

If you are making an investment into a DST with a REIT exit, you are aligning yourself with the sponsor in a long-term way. It's more important than ever to understand what you are getting yourself into. I'd encourage you to evaluate the REIT first, then the DST second. And in some ways, the DST becomes less (*slightly less*) important in that scenario. It's a gateway into the investment you actually want to make.

I'd recommend you put yourself in a position to take advantage of a REIT exit as an OPTION, not an OBLIGATION. Test the waters with the sponsor for 3-5 years as they hold the properties in the DST, then decide if you want to align with them as a part of your long estate plan.

Last (and best) recommendation: Ask your broker what the funds from operations (FFO) ratio is. All REITs are required to show their FFO calculations on their public financial statements. The FFO figure is typically disclosed in the footnotes for the income statement. If the FOO ratio is less than 100%, hard pass. That means they are paying dividends out of investor capital or debt, instead of NOI. That easy question to answer will be a really great litmus test in your due diligence toolbox.

If you are evaluating a REIT, it would be wise and prudent to do your homework and select the appropriate professional to guide you. It can be a wonderful tool.

 Great summary.

I want to make sure I fully understand my options going forward. From your advice I want to delay going into a REIT.

1031 --> DST --> REIT Once I'm in a REIT I can no longer transfer w/o paying taxes.

1031 --> DST --> DST2 --> DST3...... Can I move from DST to DST w/o paying taxes?

1031 --> DST --> 1031(2) Can I move from DST back to into 1031 Real estate?

Thanks, Pete

[Jon Taylor]

Quote from @Pete Harper:

Quote from @Jon Taylor:

@Pete Harper - 

Section 721 of the Internal Revenue Code allows an investor to exchange property held for investment or business purposes for shares in a Real Estate Investment Trust (REIT) without triggering a taxable event. The transaction allows investors to increase the liquidity and diversification of their real estate investments while deferring costly capital gains and depreciation recapture taxes that may result from the sale of a property.

Benefits:

REITs also can provide the same ongoing benefits of real estate ownership including income, depreciation tax shelter, principal pay down, and appreciation. Many REITs continue to make acquisitions on an ongoing basis. This allows the investor to benefit from future buying opportunities in the REIT without triggering any capital gains or depreciation recapture tax events. *Please note: As Dave mentioned, not all REITs allow for ongoing depreciation, but some do. It's important to understand the difference, and I'd recommend sticking with the REIT with depreciation advantages.

The Tax Cut and Jobs Act (TCJA) includes a 199A deduction and applies to certain income from pass-through entities (including REIT dividends) and allows individuals to take the 20% deduction against REIT dividend distributions that yields an effective tax rate of 29.6% or 37% (80% for upper bracket filers). But the 199A is scheduled to sunset in 2025 under the TCJA unless made permanent.

It wouldn't be uncommon for some investors to only realize taxable income on 40-50% of their dividend distributions in today's current environment (I have seen this personally).

You asked about fees, so one quick comment. Often times the transaction between the DST and the REIT involve a significantly lower commission for the brokers. As such, many aren't incentivized to advise you along that path (sad but true). Instead, the commission is passed along to the investor in the form of increased equity.

Most of the time, the REIT has liquidity as an option. This is great of your accountant who may choose to advise that you liquidate shares during a tax year where you realize some loss elsewhere. It's also a great way to pass buildings down to your kids who want nothing to do with the active management business. Instead of saddling them with a $5M commercial property (for instance), you can turn that into 166k shares and divide them amongst your kids (who are in line to get a full step-up in basis when you pass away).

Gotchas:

The UPREIT is sometimes an option, and sometimes a mandate. It's really important to understand the difference. There are examples of DSTs that included an exit into a REIT that DID NOT ALLOW the investor to do a 1031 exchange. The investor was unaware of this previously. Horrible.

The REIT is essentially a "blind pool" investment. The Trustee of the REIT can buy and sell properties within the REIT without triggering a capital gain event to you as the investor, however, this flexibility also allows the operators to potentially add properties to your investment portfolio that may expose you to risks or asset classes you were previously unaware of.

There are a couple of sponsors I am aware of that carve individual properties out of the REIT, into a DST, then pull them back into the REIT at a significant mark-up to the DST investor. This is important to understand on the front end when you are investing in the DST.

Summary:

If you are making an investment into a DST with a REIT exit, you are aligning yourself with the sponsor in a long-term way. It's more important than ever to understand what you are getting yourself into. I'd encourage you to evaluate the REIT first, then the DST second. And in some ways, the DST becomes less (*slightly less*) important in that scenario. It's a gateway into the investment you actually want to make.

I'd recommend you put yourself in a position to take advantage of a REIT exit as an OPTION, not an OBLIGATION. Test the waters with the sponsor for 3-5 years as they hold the properties in the DST, then decide if you want to align with them as a part of your long estate plan.

Last (and best) recommendation: Ask your broker what the funds from operations (FFO) ratio is. All REITs are required to show their FFO calculations on their public financial statements. The FFO figure is typically disclosed in the footnotes for the income statement. If the FOO ratio is less than 100%, hard pass. That means they are paying dividends out of investor capital or debt, instead of NOI. That easy question to answer will be a really great litmus test in your due diligence toolbox.

If you are evaluating a REIT, it would be wise and prudent to do your homework and select the appropriate professional to guide you. It can be a wonderful tool.

 Great summary.

I want to make sure I fully understand my options going forward. From your advice I want to delay going into a REIT.

1031 --> DST --> REIT Once I'm in a REIT I can no longer transfer w/o paying taxes.

1031 --> DST --> DST2 --> DST3...... Can I move from DST to DST w/o paying taxes?

1031 --> DST --> 1031(2) Can I move from DST back to into 1031 Real estate?

Thanks, Pete

 @Pete Harper - 

1031 --> DST --> REIT Once I'm in a REIT I can no longer transfer w/o paying taxes. - correct

1031 --> DST --> DST2 --> DST3...... Can I move from DST to DST w/o paying taxes? - yes. A DST is considered real property held for investment and can be used as a partial or full 1031 exchange option.

1031 --> DST --> 1031(2) Can I move from DST back to into 1031 Real estate? Per the above, the DST is considered real estate. So you can move from DST to a smaller local property through the 1031.