The term Real Estate Investment Trust (REIT) has been around for a long time. You may trace the roots back to President Eisenhower when legislation was passed by Congress enabling a new style of investing including the attributes of stock base investments and real estate. Acquisition of a REIT is the Mission.
By Al DiNicola, AIF®, CEPA ™
July 14, 2023
DST 1031 Specialist
NAMCOA® – Naples Asset Management Company®, LLC
Securities offered through MSC-BD, LLC
REITs provided an opportunity to invest in high quality real estate with other like-minded (unknown) investors. Over the past 60 plus years the structure and functions of REIT have evolved. There may be a variety of assets or properties that make up the REIT portfolio. REITs may be public or private. Public REITS would trade on the national stock exchange. REITs would be considered passive investments because the portfolio is professionally managed along with requirements of distributions to be made to the investors.
The Mission: Acquiring a REIT
Cash investors may invest directly into a REIT and enjoy the tax advantage that many investors seek. Real estate investors have a few options to participate in a REIT. An individual property owner may contribute their property to a REIT. This is known as a 721 UPREIT. Generally, the contribution investor transfers the real estate property into the REIT (operating partnership) and would receive “units” in return. For the purposes of this writing, we will not discuss the percentage of contribution and the percentage of units an investor may receive in return. Technically the investor is moving from real estate which is considered real property into a REIT which is considered a security. The other option a real estate investor may use to convert their real estate into a REIT would be to enter into a process involving a 1031 tax deferred exchange. You may not utilize a 1031 exchange (directly) into a REIT in one step and immediately. As a reminder the 1031 exchange must be utilized when exchanging like kind property (real property) held for investment or business purposes. REITS falls under the classification of personal property. However, it is possible to move into a REIT in a few steps.
Mission Strategy: DST.
The strategy involves utilizing a Delaware Statutory Trust (DST). DSTs began their popularity starting in 2004. This may be a relatively new strategy for some investors. DSTs in many cases have replaced Tenants in Common (TIC) for fractional ownership. Revenue Ruling 2004-86 (IRS), specifically referenced a DST as a like-kind investment for a 1031 exchange. Investors may utilize the DST as the replacement property via 1031 exchange when selling their investment property. Converting the real estate into a DST moves the investor one step closer to a REIT investment, if that is the ultimate goal.
DSTs offer investors the ability to diversify their real estate holdings into different selected asset classes or geographic locations. The investor would own a beneficial interest in the Trust. The beneficial interest qualifies as a 1031 exchange just like any traditional real estate used as a replacement property in a 1031. The first part of the mission has been accomplished by moving into a DST.
Mission Critical Options
When DSTs are prepared to be sold by the sponsors, the sale may be referenced as a liquidity event. There are typically three exit strategies: simply collect your proceeds and pay capital gains; utilize a 1031 exchange into another DST, and; utilize a 1031 exchange and move back into a traditional real estate holding. Recently a fourth option has been introduced by certain sponsors of DSTs. Some sponsors have affiliations with large institutional REITS that provide investors with the option to move into a REIT utilizing what is known as §721 UPREIT.
Moving the Mission Forward
The second part of the mission would be to move into the REIT. The exact timing of the second part may be somewhat fluid. The ability to move into the REIT will be determined when the liquidity event occurs (also known as the DST going full cycle). Moving into the REIT is a well thought out goal for more than one reason. The liquidity event is determined by the sponsor. There is also what may be referenced as a safe harbor or holding period. Typically, DST sponsors will seek to hold the assets within the individual DST for a period of time. The holding period may be tied to recovering any acquisition cost associated with the structure of the DST. Two to three years may be an adequate period of time in certain situations.
If the investor’s overall mission is to defer capital gains, then the DST does accomplish this and moving into the REIT may provide other solutions as well. This is not intended to be a knee jerk activity.
Here is a review of the mission (if you accept). Investors sell property utilizing a 1031 exchange. The proceeds go to a Qualified Intermediary (QI). The investor identified DST properties (within the required 45-day identification period) and QI funds the acquisition. When the DST is sold in a few years the investor can direct the proceeds into the REIT. The investor will own Operating Partnership Units (OP). What have you gained from your mission? You deferred capital gains on the 1031 exchange into the DST. When you converted into the REIT you paid no taxes on the conversion. As long as you own the REIT you will pay no capital gains taxes. However, you will be responsible for paying any taxes on the income that is distributed from the DST or the REIT based on your personal income tax bracket as well as state of residence. If the end mission is for the REIT to become part of your estate to be passed down your beneficiary will enjoy a step up in basis and not be subjected to any capital gains taxes.
Post Mission Fall Out, If any
You successfully completed your mission of converting your real estate into a 721 UPREIT (via 1031 & DST execution). Once you have moved into a REIT you cannot utilize another 1031 exchange again. Federal and state taxes (if applicable) will be due if you sell your REIT. There is also a safe holding period of 1-2 years to own the OP Units prior to selling. There is an advantage if you were to sell your REIT you may peel off some of your units and not liquidate the entire REIT portfolio. This is not the case with a DST. Some investors seek the added flexibility of the REIT. There is a word of caution as always. Read the Private Placement Memorandum (PPM) or other offering documents and ask questions to your CPA and tax advisors. Over the past few years, the quality of the DST offerings that contain the 721 UPREIT option has increased in offerings.
Exercising the 721 UPREIT option is based on individual investor suitability. NAMCOA has additional insight into the DST structure as well as the 721-conversion option. There are benefits to both strategies. If you have questions, please contact us.
DSTs are not for all investors.
The acquisition of a DST is for accredited investors only. Contact your investment adviser for additional details on how a DST may be a solution to your 1031 Exchange and suited for your investment future. For more information on how to properly set up an IRC 1031Tax Deferred Exchange or if you are an accredited investor and would like additional information on a DST contact Al DiNicola at 239-691-8098 or email email@example.com.
This is not an offer to purchase or solicitation to purchase any security, as such be made only through an offering memorandum or prospectus. Investing in securities, real estate, or any investment, whether public or private, involves risk, including but not limited to the potential of losing some or all of your investment dollars when you invest in securities. You should review any planned financial transactions that may have tax or legal implications with your personal tax or legal advisor. NAMCOA, LLC is a Registered Investment Advisor, regulated by SEC (Securities and Exchange Commission). Our corporate office is located at 999 Vanderbilt Beach Road, Suite 200, Naples Florida 34108. Securities Offered through MSC-BD, LLC, Member of FINRA/SIPC. 8215 SW Tualatin -Sherwood Rd, Suite 200 Tualatin, OR 97062. MSC-BD, LLC and NAMCOA are independently owned and are not affiliated.
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