One thing I have learned in nearly 20 years working with 1031 exchange investors, is that people do not like paying their capital gains tax on appreciated Real Estate. The second thing I have learned is that investors can be so fixated on avoiding the tax that they let their guard down. They start the Google Search and allow themselves to be sold on some obscure investment product or strategy. I tell all my prospective clients the same thing. If you have tax to pay, you are doing something right. Do not turn something right into something so very wrong by hastily investing into a strategy that sounds too good to be true. An investor can easily lose more money than the amount of tax that was due. 

The most popular strategy used for deferring capital gains tax is the 1031 exchange. I am often asked if it is possible to exchange into a REIT, or Real Estate Investment Trust. Unfortunately, the answer to that question is no. Not directly anyway. In this article I will outline a strategy where an investor can make an exchange into a 1031 exchange eligible investment property and eventually, exchange that asset for REIT shares. The strategy is called the 721 UPREIT and it is becoming exceedingly popular. This strategy has been around for long time but has recently gained traction as an alternative (or in conjunction with) a traditional 1031 exchange. What is happening is that what was once a little used strategy is now heavily promoted on the internet. I have found that once an investment product is promoted and sold with mass marketing more and more people invest but less people understand what they are investing in. My goal is to help you understand the strategy and products involved so you can make an informed decision as to whether this makes sense for you.

The 721 UPREIT

I will explain how a 721 UPREIT transaction works, but I must caution that anyone implementing a strategy like this should first review it with their CPA or Qualified Tax Advisor. In most instances, the Advisor/Rep that sells the product is not going to be qualified to offer tax advice. I do not offer tax advice. Generally speaking, an investment property owner can exchange that property for Operating Partnership Units in a Real Estate Investment Trust. U-P-R-E-I-T is an acronym for Umbrella Partnership Real Estate Investment Trust. A Real Estate Investment trust or REIT is much like a Mutual Fund except the REIT owns Investment Property instead of Securities. One of the primary qualifiers for a Real Estate Investment Company to qualify as a REIT is that it must distribute 90% of taxable income in the form of shareholder dividends. For this reason, investors seeking income may wish to consider investing in REITs.   Where does the Partnership come in? You cannot exchange your property for REIT shares, that does not qualify under section 721 or IRC Section 1031. For this to work the REIT must create an Operating Partnership and be a partner in that OP. The REIT can then exchange OP units for the Investment Property. Once you exchange for OP Units, there is no going back. You will receive the same dividend that the REIT shareholder receives. As long as you hold the OP Units, you will not recognize Capital Gains Tax from the sale, or transfer of your Investment Property. At some point, you may wish to convert your OP Units for REIT shares. At that point, you would recognize the Capital Gains Tax on the portion that you convert to REIT shares. You should work with your CPA and calculate what this tax liability would be BEFORE you decide to do the UPREIT transaction. You should be able to calculate the tax due on the whole investment and then pro-rate it for smaller amounts that you may wish to convert to REIT shares. Make sure to factor in the Depreciation Recapture Tax.   With a 1031 exchange, if you cash out a portion of your exchange proceeds and expect to pay tax on it, you would be required to pay your entire Depreciation Recapture Tax first, then the pro-rata portion of Local, State and Federal Capital Gains Tax. This may or may not be a big number, but you do not want to be blind sided by this when you are looking for liquidity.

What are the chances that you would have an appreciated Investment Property for sale that a REIT would want to own? And what are the chances that you would want to own shares in that REIT? I would say chances are slim. There is an answer for that. The REIT will typically have a pipeline of potential acquisitions. Rather than acquire directly, the REIT can first deposit the property into a DST structure and offer beneficial interests in the DST to individual 1031 exchange investors.   The Beneficial DST interests qualify for the 1031 exchange. At this point the investor has completed an ordinary 1031 exchange transaction into a Delaware Statutory Trust. That transaction must be held for investment, typically two years, then the REIT can offer the option to convert the Beneficial Interest for OP Units in the REIT. The entire transaction is pre-arranged. The REIT has selected a potential acquisition but instead of acquiring directly, the REIT will acquire through the DST allowing individual investors to participate in the transaction and defer their tax along the way. Once you decide to go this route, you should be prepared to follow through and own the REIT shares. My first question is, can I retain my beneficial interest in the DST or am I obligated to convert to OP Units? Technically, you can still exchange the DST interest. Once you exchange for OP units there is no going back. What if the fundamentals of the REIT have changed? What if the property is performing better than expected and I want to keep my DST interest? What if the property is underperforming? Now I want to convert to OP Units but can the REIT decline to convert? Remember, in a DST, the Sponsor/Trustee makes all decisions. No voting rights. Do you have an option or an obligation to convert to OP Units? These are all good questions to speak with your Advisor about. Why convert to REIT shares? Risk Management. Diversification helps mitigate risk. The conversion will allow you to go from ownership in one property to a diversified portfolio. Some properties will over perform, some will underperform. Over time, this should result in more consistent returns. Correlation could be a concern. Most REITs identify with a particular asset class. Multifamily, Industrial, Retail, Medical Office. Most of the properties will likely be in the one asset class. I would still suggest that if you are a conservative investor owning a portfolio of properties is less risky.

Fees

As a 721 UPREIT investor or 1031 DST investor you are now making a transition from Real Estate ownership to owning a security. Typically, 1031 exchange investors that exchange into DSTs are seeking a passive investment. These investors are at a point in their life where they no longer wish to actively manage investment properties. There is a cost to being a passive investor. There is also a cost to bringing a product like this to market. Front end loads include Acquisition Fess, Placement Agent fees, Dealer Fees, Selling Commissions and/or Investment Advisory fees. Ongoing Fees include Asset Management Fees at the Sponsor level and Property Management fees at the property level. DST fees are straight forward. Go to the Table of Contents and look for the Estimated Use of Proceeds. The fees are spelled out in table format. There is a simple rule of thumb when looking at upfront fees. You should be able to find out what the fully loaded going in cap rate is for any DST deal. That is the price paid for the property plus all fees included in the offering. Compare that to recent sales comps. Again, as a passive investment, the cost will be higher but if a Sponsor is doing their job right they should be able to make an acquisition at a favorable enough price to factor in the load and end up with a reasonable fully loaded sales comp. The REIT in the 721 UPREIT transaction will also have fees. Non-Traded REITs have higher fees than Traded REITs. You really need to lean on your Investment Advisor or Registered Representative to break these fees down for you.

Liquidity

There is no secondary market for DST investments so if you think you will have a liquidity need before 6-10 years, this is not for you. You can sell your interest to another investor but at a 20-30% discount. Do not let a rep tell you they can “get you out” by selling your interest to a new investor. I am not aware of any transactions like this taking place and I would be concerned with the Broker Dealer that would let that happen.  Investors go into the 721 UPREIT because there is potential for liquidity. If you exchange your DST interest for OP Units in a Publicly Traded REIT, and then convert those OP Units to freely traded shares, you will most certainly have a liquidity event. The question is, at what price? The market will tell you that. What if you converted your OP Units into shares, a taxable event, and then Covid-19 happens? Your shares are worth 40% less than what you hoped for. Your tax is still due. Now you are a speculator in the market hoping for a rebound so you can sell your shares, pay your tax and keep what’s left. Not a good plan. What if you trade your OP Units for shares in a non-traded REIT? One of the potential benefits of non-traded REITs is that you are not subjected to price swings in volatile markets. The shares do not trade. What price will you receive when you sell your shares? There is a valuation process. You may wish to do some independent research on this subject. You can start here Public Non-Traded REITs—Perform a Careful Review Before Investing | FINRA.org. There is more to consider. Non-Traded REITs have redemption policies. The redemption policy may limit the amount of shares the REIT will repurchase on a monthly, quarterly, or annual basis. If there is a flood of redemption requests, all redemption requests may not be honored. This could be a problem if the share conversion were made and the Capital Gains Tax were realized. The investor may be counting on that liquidity to pay the tax.

Summary

This is a two-part transaction, so an investor needs to be comfortable with the real estate in the DST as well as the performance of the REIT. You must consider the possibility that the DST investment does not end up in the REIT. A lot can happen over a two-year holding period. The REIT should be fundamentally sound. Do not chase high yields, do look for sustainable yields. A payout ratio above 100% could be a red flag. That means the REIT is paying out more in dividends than it is earning. That may not be sustainable. If your goal is to diversification, the 721 UPREIT could be a nice strategy. As far as liquidity is concerned, as I mentioned, there is potential for liquidity in a 721 UPREIT transaction but it may not be a sure thing. If you are certain you need liquidity in the near future, leave that amount out of your exchange. It will be Boot, you owe the tax, but you know you have the money. Finally, as I tell all DST clients and prospective clients, you should only work with sponsors with extensive track records. The same applies with the 721 UPREIT transaction. An experienced sponsor with an extensive track record is more likely to deliver on projections and provide liquidity when the time comes.

Eric Bicknese is a Registered Representative with Nationwide Planning Associates, Inc. Member FINRA, SIPC. Representatives are registered through, and securities are sold through Nationwide Planning Associates, Inc., Member FINRA/SIPC, located at 115 West Century Road, Suite 360, Paramus, NJ 07652.  Investment advisory services are offered through NPA Asset Management, LLC.  Insurance sold through licensed NPA Insurance Agency, Inc. agents. Nationwide Planning Associates and its representatives do not provide tax or legal advice. Consult with your tax advisor or attorney regarding specific tax issues.

This advertisement is for information only. It is not to be construed as an offer to sell or a solicitation of an offer to buy any security or undertake any investment strategy. Specific recommendations can only be made by request and with the review of the client’s investment portfolio. You are encouraged to consult your tax advisor to determine how an investment program will affect your individual tax circumstances.