§ 721 UPREIT Mission Possible via DST  

The term  Real Estate Investment Trust (REIT) has been around for a long time.  You may trace the roots back to President Eisenhower when legislation was passed by Congress enabling a new style of investing including the attributes of stock base investments and real estate. Acquisition of a REIT is the Mission.  

By Al DiNicola, AIF®, CEPA ™
adinicola@namcoa.com
July 12, 2023
DST 1031 Specialist
NAMCOA® – Naples Asset Management Company®, LLC
Securities offered through MSC-BD, LLC

REITs provided an opportunity to invest in high quality real estate with other like-minded (unknown) investors. Over the past 60 plus years the structure and functions of REIT have evolved. There may be a variety of assets or properties that make up the REIT portfolio. REITs may be public or private. Public REITS would trade on the national stock exchange.  REITs would be considered passive investments because the portfolio is professionally managed along with requirements of distributions to be made to the investors.

The Mission: Acquiring a REIT

Cash investors may invest directly into a REIT and enjoy the tax advantage that many investors seek. Real estate investors have a few options to participate in a REIT.  An individual property owner may contribute their property to a REIT. This is known as a 721 UPREIT. Generally, the contribution investor transfers the real estate property into the REIT (operating partnership) and would receive “units” in return. For the purposes of this writing, we will not discuss the percentage of contribution and the percentage of units an investor may receive in return.   Technically the investor is moving from real estate which is considered real property into a REIT which is considered a security.   The other option a real estate investor may use to convert their real estate into a REIT would be to enter into a process involving a 1031 tax deferred exchange. You may not utilize a 1031 exchange (directly) into a REIT in one step and immediately. As a reminder the 1031 exchange must be utilized when exchanging like kind property (real property) held for investment or business purposes. REITS falls under the classification of personal property.    However, it is possible to move into a REIT in a few steps.

Mission Strategy: DST.

 The strategy involves utilizing a Delaware Statutory Trust (DST).    DSTs began their popularity starting in 2004. This may be a relatively new strategy for some investors.  DSTs in many cases have replaced Tenants in Common (TIC) for fractional ownership. Revenue Ruling 2004-86 (IRS),  specifically referenced a DST as a like-kind investment for a 1031 exchange. Investors may utilize the DST as the replacement property via 1031 exchange when selling their investment property.   Converting the real estate into a DST moves the investor one step closer to a REIT investment, if that is the ultimate goal.

DSTs offer investors the ability to diversify their real estate holdings into different selected asset classes or geographic locations. The investor would own a beneficial interest in the Trust. The beneficial interest qualifies as a 1031 exchange just like any traditional real estate used as a replacement property in a 1031.   The first part of the mission has been accomplished by moving into a DST.

Mission Critical Options

When DSTs are prepared to be sold by the sponsors, the sale may be referenced as a liquidity event. There are typically three exit strategies: simply collect your proceeds and pay capital gains; utilize a 1031 exchange into another DST, and; utilize a 1031 exchange and move back into a traditional real estate holding.  Recently a fourth option has been introduced by certain sponsors of DSTs.  Some sponsors have affiliations with large institutional REITS that provide investors with the option to move into a REIT utilizing what is known as §721 UPREIT.

Moving the Mission Forward

The second part of the mission would be to move into the REIT. The exact timing of the second part may be somewhat fluid. The ability to move into the REIT will be determined when the liquidity event occurs (also known as the DST going full cycle).   Moving into the REIT is a well thought out goal for more than one reason.  The liquidity event is determined by the sponsor.  There is also what may be referenced as a safe harbor or holding period. Typically, DST sponsors will seek to hold the assets within the individual DST for a period of time.  The holding period may be tied to recovering any acquisition cost associated with the structure of the DST.  Two to three years may be an adequate period of time in certain situations.

If the investor’s overall mission is to defer capital gains, then the DST does accomplish this and moving into the REIT may provide other solutions as well. This is not intended to be a knee jerk activity.   

Mission Review

Here is a review of the mission (if you accept). Investors sell property utilizing a 1031 exchange. The proceeds go to a Qualified Intermediary (QI).  The investor identified DST properties (within the required 45-day identification period) and QI funds the acquisition. When the DST is sold in a few years the investor can direct the proceeds into the REIT. The investor will own Operating Partnership Units (OP).  What have you gained from  your mission?  You deferred capital gains on the 1031 exchange into the DST.  When you converted into the REIT you paid no taxes on the conversion.   As long as you own the REIT you will pay no capital gains taxes.  However, you will be responsible for paying any taxes on the income that is distributed from the DST or the REIT based on your personal income tax bracket as well as state of residence.  If the end mission is for the REIT to become part of your estate to be passed down your beneficiary will enjoy a step up in basis and not be subjected to any capital gains taxes.

Post Mission Fall Out, If any

You successfully completed your mission of converting your real estate into a 721 UPREIT (via 1031 & DST execution). Once you have moved into a REIT you cannot utilize another 1031 exchange again.  Federal and state taxes (if applicable) will be due if you sell your REIT.  There is also a safe holding period of 1-2 years to own the OP Units prior to selling. There is an advantage if you were to sell your REIT you may peel off some of your units and not liquidate the entire REIT portfolio. This is not the case with a DST. Some investors seek the added flexibility of the REIT.   There is a word of caution as always.  Read the Private Placement Memorandum (PPM) or other offering documents and ask questions to your CPA and tax advisors. Over the past few years, the quality of the DST offerings that contain the 721 UPREIT option has increased in offerings.

Suitability

Exercising the 721 UPREIT option is based on individual investor suitability. NAMCOA has additional insight into the DST structure as well as the 721-conversion option. There are benefits to both strategies. If you have questions, please contact us.

DSTs are not for all investors.

The acquisition of a DST is for accredited investors only. Contact your investment adviser for additional details on how a DST may be a solution to your 1031 Exchange and suited for your investment future. For more information on how to properly set up an IRC 1031Tax Deferred Exchange or if you are an accredited investor and would like additional information on a DST contact Al DiNicola at 239-691-8098 or email adinicola@namcoa.com.

This is not an offer to purchase or solicitation to purchase any security, as such be made only through an offering memorandum or prospectus. Investing in securities, real estate, or any investment, whether public or private, involves risk, including but not limited to the potential of losing some or all of your investment dollars when you invest in securities. You should review any planned financial transactions that may have tax or legal implications with your personal tax or legal advisor. NAMCOA, LLC is a Registered Investment Advisor, regulated by SEC (Securities and Exchange Commission). Our corporate office is located at 999 Vanderbilt Beach Road, Suite 200, Naples Florida 34108. Securities Offered through MSC-BD, LLC, Member of FINRA/SIPC. 8215 SW Tualatin -Sherwood Rd, Suite 200 Tualatin, OR 97062. MSC-BD, LLC and NAMCOA are independently owned and are not affiliated.

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Social Media platforms are solely for informational purposes. Advisory services are only offered to clients or prospective clients where the advisory firm and its representatives are properly licensed or exempt from licensure. Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital. No advice may be rendered by NAMCOA unless a client service agreement is in place.

Thank you.

1033 Tax Deferred Exchange – A rescue vehicle?

You have been served.

When an investor receives a letter or notice from a government agency that the entity wants to “take your property” there is a variety of thoughts that go through your mind. There is a tax deferred section of the IRC that may be a life line or rescue to replace your property. IRC §1033 may be utilized in the case of replacing your property when taken by eminent domain or condemnation.

By Al DiNicola, AIF®, CEPA ™
adinicola@namcoa.com
May 8, 2023
DST 1031 Specialist
NAMCOA® – Naples Asset Management Company®, LLC
Securities offered through MSC-BD, LLC

1033 may also be utilized when your property is destroyed by a natural disaster.  The 1033 may be the not so often used “cousin” to the 1031 tax deferred exchange. While there are similarities between 1031 and 1033 there are also differences to be addressed.

There is the ability to defer capital gains on real estate property used for business or investment purposes in both sections.  The capital gains that may be due would differ depending on individual state of residency.  Total capital gains tax may be 20% to 30% on the capital gains and potentially more depending on the state of residency. 1031 & 1033 are strategies that may temporarily mitigate taxes and offer alternatives.

The 45-day identification period and the 180-day closing period challenge investors to comply with the 1031. There is also the requirement to replace with like kind which has a broad interpretation.  1033 has a different set of rules which may be driven by the fact that the relinquishing of the investment property was outside the investor’s control.  The property was either taken by a government entity or destroyed in a natural disaster.

Major benefits of the  1033 exchange

Potential access to a Cash Out option.

A few of the financial requirements in the 1031 exchange require the investor to reinvest all the cash and to replace the debt if there was a loan paid off. The other financial requirement is to replace the total value of the relinquished property. There are a few options in the 1033 exchange with the cash and debt components.  Investors need only to match (or exceed) the total value of the relinquished property. The combination of cash and debt may be designed by the investor. Here is an example of a 1033 structure.  The investor received proceeds from a condemnation of their property for building a new road. The total value of the property was $1,000,000 and the investor had a $300,000 loan on the property. The cash equity would be $700,000.  The investor could purchase another property with a value of $1,000,000 and potentially obtain a loan of 60%  ($600,000). This would require a cash equity component of $400,000. The remaining cash of $300,000 may be retained TAX FREE by the investor.

“Equal and Up Rule” Replacing Equity & Debt

IRC §1031

  • Equity in the replacement property must be equal to or greater than the net equity of the relinquished property. Equity cannot be replaced by additional debt.
  • The value of debt on the replacement property must be equal to or greater than the value of debt relieved on the relinquished property. Debt can be replaced with additional equity (cash). 

IRC §1033

  • The cost of the replacement property must be equal to or greater than the net proceeds received. Equity can be replaced with additional debt.
  • The value of debt on the replacement property must be equal to or greater than the value of debt relieved on the property converted. Debt can be replaced with additional equity (cash).

Who needs a Qualified Intermediary?

Yes, you do if you are utilizing a 1031 exchange. Under IRC Section 1031 the investor may not take constructive receipt of any proceeds in a 1031.  Taking constructive receipt (if even in an escrow account) would be subject to taxes on the capital gain.  This is also considered “boot”. There is no requirement for an investor whose property was taken by eminent domain or destroyed by a natural disaster to utilize the services of a QI.  What can an investor do with the money until the exchange is completed? The investor may invest the funds in a money market account, personal investment, or even the stock market. However, when the time comes to complete the exchange, the total value needs to be replaced.

Time is on your side.

We briefly reviewed the time constraints of the 1031 exchange. The flexibility of the 1033 exchange may give the investor a period of 2 to 3 years to complete their exchange.   1033 is considered a forced conversion. The other interesting requirement is there is  no requirement to identify any specific replacement property and report to anyone.  In the 1031 the 45-day identification list must be turned into the QI.  This 1033 provision opens the door for the investor to identify almost any replacement property to finalize their purchase. The title is passed to the investor on the replacement property when the exchange is completed.

What to do with the cash?

There is the potential an investor may receive cash from two sources. The two sources may be when the government acquires your condemned property, or you receive the insurance proceeds on the destroyed property. Since you do not need a QI you can receive the cash. There is always the question of what do you do with cash? You are free to use or invest the proceeds in any vehicle you decide.  Typically, a more conservative prudent investment would be suggested.  The rationale would be you will need the proceeds to be reinvested to acquire the replacement property to complete the exchange.  If your investment principal goes down (as in the stock market or risky investment) you will have less capital to complete the exchange.   Remember the 1033 exchange requires the investor to match the entire value of the relinquished property in the replacement property.

Like Kind versus Like Kind versus Similar Use

The words “Like Kind” appear in both the 1031 and 1033 exchange requirements. However, there are differences between a 1031 and a 1033 exchange in the standard that is used to limit what you can buy as replacement property. In the 1033 exchange the replacement property must be “similar or related in service or use” to the property that was lost in the casualty or condemnation. This additional restriction is more restrictive than the like kind standard under IRC 1031.  There is an alternative standard for replacement property, but only if the property is lost due to a condemnation and was held for productive use in a trade or business. In this case, the replacement property qualifies if it is “like-kind” to the converted property. Locating a replacement property that would be considered “like-kind” may be easier to comply with than the “similar or related in service or use” requirement.  Bottom line if your office property was destroyed by a natural disaster then your replacement must be similar use (office).   There is one other wrinkle with regards to replacement property.  Under the 1033 you as an investor may purchase 80% control of a corporation that owns the replacement property. This would be rather than using the like kind for the exchange.      

Final Thoughts

There are advantages and disadvantages with every investment opportunity. The 1033 tax deferred exchange is a tool investor need to understand. Having the right understanding can improve the overall positioning of the investor.  The disadvantage may be the extended amount of time that investors have to make the decision on replacement properties.  We have seen investors waiting for something “better” to come along. Occasionally having extra time may not be a positive and creates a relaxed feeling.  All investments need to have the proper due diligence.

Accredited investors seeking replacement properties with a passive investment will seek out Delaware Statutory Trust (DST). The advantage with the DST structure affords the investor with non-recourse debt on the prepackage investment alternatives.  Contact us for additional information on the DST structure and function for your potential investment solutions.

DSTs are not for all investors. The acquisition of a DST is for accredited investors only. Contact your investment adviser for additional details on how a DST may be a solution to your 1031 Exchange and suited for your investment future. For more information on how to properly set up an IRC 1031Tax Deferred Exchange or if you are an accredited investor and would like additional information on a DST contact Al DiNicola at 239-691-8098 or email adinicola@namcoa.com.

This is not an offer to purchase or solicitation to purchase any security, as such be made only through an offering memorandum or prospectus. Investing in securities, real estate, or any investment, whether public or private, involves risk, including but not limited to the potential of losing some or all of your investment dollars when you invest in securities. You should review any planned financial transactions that may have tax or legal implications with your personal tax or legal advisor. NAMCOA, LLC is a Registered Investment Advisor, regulated by SEC (Securities and Exchange Commission). Our corporate office is located at 999 Vanderbilt Beach Road, Suite 200, Naples Florida 34108. Securities Offered through MSC-BD, LLC, Member of FINRA/SIPC. 8215 SW Tualatin -Sherwood Rd, Suite 200 Tualatin, OR 97062. MSC-BD, LLC and NAMCOA are independently owned and are not affiliated.

SOCIAL MEDIA

Social Media platforms are solely for informational purposes. Advisory services are only offered to clients or prospective clients where the advisory firm and its representatives are properly licensed or exempt from licensure. Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital. No advice may be rendered by NAMCOA unless a client service agreement is in place.

Thank you.

NAMCOA® – Naples Asset Management Company®, LLC