Simplifying Real Estate Ownership Through Tax-Deferred Strategies

While directly owning real estate can be highly profitable, it comes with challenges regarding the active management of properties, including collecting rents, negotiating leases, dealing with tenants, and building upkeep and maintenance, amongst other things, which can be quite burdensome, particularly as people age.

This article outlines a two-step process for property owners to utilize Internal Revenue Code (IRC) 1031 to gain access to a professionally managed pool of institutional-quality real estate holdings. Through this approach, owners can receive income from passive fractional ownership in the pool while deferring capital gains on the sale of their exchanged property. But first, let’s define what a 1031 exchange is and how it came about.

The 1031 Exchange

Most owners of investment real estate are probably aware of the benefits of Internal Revenue Code section 1031, which allows for a tax-deferred exchange of real estate provided certain conditions are met. As a bit of history, 1031 exchanges have been around for over 100 years, and initially, the seller and buyer had to exchange their respective properties with each other simultaneously. Luckily, things have significantly changed since then, allowing for much more flexibility in timing and property selection.  Modern 1031 exchange rules allow for “delayed exchanges” where real estate investors can sell their property before acquiring a replacement property and eliminate the onerous requirement for a simultaneous exchange.

That said, it can sometimes be challenging to meet the specific conditions for a real estate investor to use Internal Revenue Code 1031, specifically the rules to identify the replacement property within 45 days and close within 180 days of the sale of the property to be exchanged. Also, there is the requirement to exchange “like-kind” property, which, while this does allow for a wide selection of property types, does not allow one to exchange directly into a diversified pool of holdings like that found in a Real Estate Investment Trust (REIT.)

Fortunately, a two-step process will eventually allow the owner to own a diversified investment pool. The first step involves using a Delaware Statutory Trust, or DST.

Step One: 1031 Exchange to a DST

In this first step, an investor sells their property and uses IRC 1031 to exchange for a beneficial interest in a DST, which is their replacement property.

Delaware Statutory Trusts were created in 1988, and their advantages include:

1. Trading active real estate management for a passive role. Actively managed real estate can be exchanged for a passively held interest in a DST.
2. Access to institutional-quality replacement property, typically a larger property that may be otherwise out of the reach of many real estate owners.
3. Simplified estate planning, as it’s easier to pass along an interest in a DST than real estate itself.
4. Faster closing times may make meeting the 1031 exchange's stringent time requirements for identifying and acquiring a replacement real estate property easier.

Step Two: Using IRC Section 721

The second step involves transferring the DST’s ownership stake into a diversified portfolio REIT, known as a 721 exchange or “UPREITING.” Section 721 of the Internal Revenue Code allows DST owners to convert their fractional ownership interest on a tax-deferred basis into an interest in the operating partnership of a REIT through an Umbrella Partnership Real Estate Investment Trust (“UPREIT”) structure.

Potential Benefits of a 721 Exchange Include:

1. Continued deferral of capital gains taxes associated with the disposition of the originally pawned real estate.
2. May increase potential tax-advantaged income based on the REIT portfolio’s performance.
3. May increase diversification with exposure to a professionally managed institutional-grade real estate portfolio invested across an array of assets and geographies
4. May increase liquidity with access to proceeds through the investment vehicle’s share redemption program
5. Upon death, REIT common shares are easily divisible and can be held or liquidated by beneficiaries at a stepped-up cost basis, resulting in a permanent tax deferral of capital gains and depreciation recapture

Final Thoughts:

Make sure to involve a CFP® professional early in the process so they can work with your other professionals to help evaluate whether this strategy is a good fit for you. Find your CFP® professional today at LetsMakeAPlan.org.