Investment vehicles that own real estate
Property used as personal vacation property
Developer inventory
Primary residence
“Flip” property
In the last category are structures that seem like real estate—partnerships, real estate operating companies, LLCs and REITs—but do not qualify because technically, the investor owns an interest in a company or partnership, not an interest in the underlying property. More specifically, in a 1031 exchange, you cannot sell a rental property and re-invest the sales proceeds into a REIT. This may seem counterintuitive, but 1031 rules explicitly require taxpayers to replace their relinquished property with real estate they own directly. The only exception to this rule is found in IRS Revenue Ruling 2004-86, which treats a beneficial interest in a trust created under Delaware law (subject to certain caveats) as a directly-owned fractional interest for 1031 purposes. Click here for a detailed overview.
THE UPREIT CONVERSION STRATEGY
But there is good news for those hoping to do a 1031 exchange today and own REIT interests in the future without triggering capital gains taxes. This is known as the “1031/721 combo strategy” or simply, the “UPREIT conversion” strategy.
HERE’S HOW IT WORKS:
STEP 1
STEP 2
STEP 3
Sell your rental property today
Conduct a 1031 exchange by investing your proceeds into a passive replacement property
Own a fractional interest in an institutional property for 2-3 years
STEP 6
STEP 5
STEP 4
Thereafter, you own REIT OP units, which can be redeemed partially or entirely on a periodic basis beginning 12 months after the conversion
Your interests in the property convert to REIT OP units under a tax-deferred transfer per IRC §721
The Operating Partnership (“OP”) of an “UPREIT” then acquires the property (UPREIT stands for Umbrella Partnership Real Estate Investment Trust)
REIT investors continue to claim their pro-rata share of depreciation (subject to personal cost basis) and ultimately benefit from a “step up” in cost basis upon death, thereby avoiding the deferred capital gains taxes altogether
STEP 7
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