<p>Ownership in passive real estate investments is becoming increasingly popular for a variety of reasons including aging real estate investors, new opportunities in the market, and the appeal of investments without management responsibilities. Two of the most common forms of passive ownership in real estate are REITs and DSTs. In this article we will discuss each and how they intersect with a 1031 Exchange, if at all. </p>
<h2>What is a Real Estate Investment Trust (REIT)?</h2>
<p>At its core, a Real Estate Investment Trust (REIT) is a company that owns and operates income-producing real estate or related assets. You can think of these as similar to a mutual fund that invests in real estate instead of stocks. These assets may include office buildings, shopping malls, multi-family housing, self-storage facilities, warehouses, and more. Some REITs provide financing to other companies that invest in these assets, in the form of mortgages or other loans. Most REITs trade on major stock exchanges, and thereby provide an investment opportunity, much like a mutual fund, to individuals who wish to benefit from investing in real estate without having to manage the day-to-day operations of real estate.</p>
<p>REITs are ongoing business entities, whose purpose is to make money for the investors by buying, managing, and selling real estate. When a REIT sells one asset, they have a fiduciary responsibility to the investors to replace that asset quickly to maximize the return on investment, and often do so using a 1031 Exchange at the REIT level.</p>
<p>However, because REITs trade on stock exchanges, investors don’t own an interest in property, but rather own a small share of the REIT much like shares of stock in any other publicly traded company. Given they do not have an ownership interest in the underlying real estate owned by these companies, under current Section 1031 rules, investors cannot sell or acquire shares in a REIT as part of a 1031 Exchange. Thus, if a REIT investor decides to sell their shares, they have created a taxable event, and may not use Section 1031 to defer the tax implications.</p>
<h2>What is a Delaware Statutory Trust (DST)?</h2>
<p>Delaware Statutory Trusts (DSTs) are legally recognized trusts, created under Delaware law, in which each investor owns a “beneficial interest” in the DST, the percentage interest is based upon the amount of the equity investment. Much like REITs, DSTs own and operate income-producing real estate or related assets. These assets may include office buildings, shopping malls, multi-family housing, self-storage facilities, warehouses, etc. Whereas REITs have the investment portfolio consisting of a number of individual properties, DSTs are often a single property. Like REITs, DSTs offer individual investors the opportunity to invest in these assets without the management headaches, additionally they offer accredited investors access to investment grade real estate that is generally more highly valued property than they could have acquired on their own. Different than REITs, the Internal Revenue Service has determined that investors in DSTs can hold undivided fractional interests in the real estate holdings of the DST rather than the company, so DST interests are considered “like-kind” property for 1031 exchange purposes.</p>
<p>Each DST is formed to acquire a unique real estate asset, or portfolio of assets. When the asset is later sold, the DST terminates, and distributes the profits directly to the beneficial owners. Those owners may choose to participate in a new 1031 Exchange, or not, depending on their unique needs, and should they not utilize a 1031 Exchange it would create a taxable event. The point is that DST investors are eligible for 1031 Exchange treatment upon sale, whereas REIT investors are not.</p>
<h2>Section 1031 Exchange Rules</h2>
<p>First, we must remember that Section 1031 exchange apply only to “real property held for productive use in a trade or business or for investment.” This phrase eliminates the prospect of structuring a 1031 Exchange for any non-real estate investment assets, as well as assets that were not held for business or investment use. REITs are structured as partnerships and prior to the Tax Cuts and Jobs Act, there was an explicit statement within the statue that eliminated the prospect of structuring a 1031 Exchange with shares in a partnership and, notes, stocks, bonds, certificates of trust, and other similar items, as well. With the 2021 revision, the word “real” was inserted before each instance of the word “property”, clearly limiting 1031 Exchanges to real estate.</p>
<h2>Do REITs and DSTs Intersect with a 1031 Exchange?</h2>
<p>An investor cannot directly invest into a REIT through a 1031 Exchange. However, by utilizing a 1031 Exchange an investor can invest directly into a DST as their Replacement Property. Should an investor’s end goal be to exit from their current investment real estate and ultimately invest into a REIT, they could utilize a 1031 Exchange to buy a DST and later use a <a href="/blog/what-difference-between-1031-exchange-and-721-exchange" title="What is a 721 Exchange?">721 Exchange</a> to accomplish such.</p>
<h2>Conclusion</h2>
<p>Whether an investor should invest in a REIT or DST, is a fact-specific inquiry. No single answer will be applicable to every investor. Thus, investors are encouraged to discuss their situations and their strategies with their financial planner, attorney, and accountant.</p>
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<p><em>The material in this blog is presented for informational purposes only. The information presented is not investment, legal, tax or compliance advice. Accruit performs the duties of a Qualified Intermediary, and as such does not offer or sell investments or provide investment, legal, or tax advice.</em></p>
