How REIT Conversions Impact Your 1031 Exchange Options
Real estate owners often consider converting their investment property into shares of a Real Estate Investment Trust (REIT). While this strategy can offer easier control and potential liquidity, it also introduces complexities for those seeking to defer capital gains taxes through a 1031 exchange. Understanding how REIT conversions affect your 1031 options is essential to avoid unwanted tax consequences.
In a 1031 exchange, you must replace relinquished property with “like-kind” real estate of equal or greater value. Direct ownership of real property typically qualifies. However, once your property is contributed to a REIT, you receive shares rather than a deeded interest in real estate. Shares in a REIT are generally treated like stocks rather than direct real estate holdings. Since 1031 exchanges require real property for both the relinquished and replacement sides, most REIT shares will not meet the like-kind requirement.
Some investors pursue a Section 721 “UPREIT” transaction as an alternative. This involves contributing your property to an umbrella partnership of the REIT in exchange for operating partnership (OP) units. You would not pay capital gains taxes at the time of conversion, and your OP units can later be converted to REIT shares. However, once the property is fully converted to shares, the 1031 exchange option typically disappears. This can limit your ability to defer gains in the future if you wish to exit the REIT position.
Maryland investors must also consider the timing of their REIT conversion. The IRS closely scrutinizes the holding period before and after you contribute a property to a REIT or take advantage of a 1031 exchange. A short holding period may trigger questions about the legitimacy of the exchange. Investors who plan their transactions well in advance and follow qualified intermediary guidelines are usually best positioned to avoid unwanted tax consequences.
If you are unsure about how a REIT conversion might impact your 1031 exchange options, consult a qualified intermediary early in the planning process. Verify that your target replacement properties or any alternative investment structures can still be acquired via a 1031 exchange. Determine how loss of direct property ownership might limit your real estate portfolio strategies going forward. With thoughtful planning, you can minimize surprises and maintain flexibility for future tax-deferred transactions.
FREQUENTLY ASKED QUESTIONS
1. Can I exchange my Maryland rental property for REIT shares using a 1031 exchange?
No. REIT shares are generally not considered “like-kind” to real property. If you convert your property into REIT shares, you will likely forfeit the ability to use a 1031 exchange in that transaction.
2. What happens if I later decide to sell my REIT shares gained from a 721 UPREIT transaction?
Once you convert to REIT shares and wish to liquidate, you typically cannot do another 1031 exchange. The IRS views shares as personal property, eliminating the deferral benefits of real property exchanges.
