There's an easier way to sell your property and defer taxes than a traditional 1031 Exchange.
It's called an UPREIT Exchange.
There are two flavors:
- 721 Exchange (Direct UPREIT)
- DST 1031 Exchange (Backdoor UPREIT)
Sounds complicated, but it's basically the same thing. DSTs just have an extra step.
Option 1: Direct UPREIT
Preferred path if you can pull it off. However, direct UPREIT transactions are typically reserved for large $30M+ deals (but there are exceptions).
Buyer gets your property, you get shares (OPUnits) in their REIT or Fund.
You can convert OP Units to common shares and pay the taxes over time.
Option 2: DST 1031 Exchange
If you have a smaller deal you'll likely need to buy into a DST (Delaware Statutory Trust) first.
The DST is a sub portfolio of the larger REIT. It's like being in the minor leagues before getting called up to the majors.
You typically have to stay in the DST for 2+ years until the REIT exercises it's option to convert your interests into the largerportfolio.
This staged transaction is designed to comply withIRS like-kind exchange rules.
Unfortunately, most DSTs are garbage.
Many seem to be created to fleece retirees who are tired of managing real estate and are looking to 1031 into a passive investment.
They have:
- Huge markups
- subpar real estate
- high fees + big commissions
- small teams with short / meh track records
The goal is not to trade into subpar deals just to defer taxes. Don't let the tail wag the dog.
That's a great way to "save" ~23% in capital gains (temporarily) then lose 100% of your investment if the deal goes south.
Instead, evaluate the real estate on its own merits and think of the tax deferral as a bonus.
Thankfully, the DST market is improving.
There are a couple DST / UPREIT options that ownClass A real estate run by world-class asset managers.
I expect more will surface over the next few years assuming the government doesn't explore the elimination of 1031 exchanges.
Ok - those are the high level concepts, below are additional details.
What Exactly is a 721 UPREIT?
A 721 UPREIT (Umbrella Partnership Real Estate Investment Trust) allows property owners to exchange their property for shares in the UPREIT. The value of these shares matches the value of the property. The UPREIT then owns and manages the property.
UPREITs are regulated by Section 721 of the tax code, so these exchanges don’t trigger a taxable event. This means you can defer paying taxes on the sale of your property. However, once you sell the UPREIT shares, you will have to pay taxes on the gains.
How Do UPREITs Work?
In a typical UPREIT setup, the REIT (Real Estate Investment Trust) owns the properties through an operating partnership (OP). When you do a 721 exchange, you sell your property to this partnership and receive OP Units instead of cash. This way, you defer capital gains tax because the sale is not treated as a taxable event.
But, most REIT managers don’t want to buy individual properties. So, many 721 exchanges involve a DST first.
Using UPREITs with DSTs
If a REIT doesn't want to buy your property directly, you can first use a DST. Here’s how it works:
- Sell Property: Sell your property and reinvest any capital gains into a DST using a 1031 exchange.
- Own Part of DST: You now own a part of the DST property.
- Convert to UPREIT: If the DST is structured with an UPREIT, you can later convert your DST ownership into shares of the UPREIT.
DST / 721 Exchange Structure:
Pros and Cons of Using UPREITs
Pros:
- Tax Benefits: You can defer capital gains taxes until you sell your UPREIT shares.
- Increased Liquidity: Real estate is usually hard to sell quickly, but UPREIT shares can be traded more easily.
- Diversification: UPREITs own many different properties, reducing your risk compared to owning just one.
- Passive Income: You no longer manage the property; instead, you earn income from the REIT, which pays dividends.
- Estate Planning: UPREIT shares can be easily divided among heirs and might avoid some taxes.
- Appreciation Potential: Additional upside appreciation potential- Access off-market deals managed by $100B+private equity firms.
Cons:
- No Future Like-Kind Exchanges: Once you have UPREIT shares, you can’t use them for another 1031 exchange.
- Less Control: You lose direct control over the property and rely on the REIT’s management.
Estate planning benefits of UPREITs:
1. can split shares among heirs so they can make individual buy / sell decisions
2. liquidity on your schedule (can sell UPREIT shares over time)
3. eventually transfer OP units to heirs on a“stepped up” basis
Is a UPREIT Right for Your 1031 Exchange?
UPREITs are usually for "accredited investors," meaning those with a high income or net worth. They might be a good fit if you:
- Have real estate with a lot of capital gains tax due upon sale.
- Own property with multiple heirs.
- Want to diversify your investments.
- Want to switch from managing property to earning passive income.
Both 1031 exchanges and UPREITs can help defer taxes on real estate sales - the decision really revolves around what role (active or passive) on your investment moving forward.
If you’re working on a 1031 Exchange or thinking about selling your property, let us know if you'd like our help trading into an UPREIT / DST 1031 Exchange:
please email info@evergreencap.com
General Disclosure: This information is for educational purposes and should not be used as investment advice. Investing involves risks, including the loss of principal. Consult with financial and tax professionals before making any investment decisions.
