The process for REIT DST 1031/721 exchanges
In brief, a REIT DST 1031/721 exchange involves the following steps and components:
- A REIT operating partnership (OP), through which the REIT owns some or all of its assets, forms a DST for the purpose of acquiring a property. The DST is intended to qualify as a disregarded entity – not a partnership – for U.S. federal income tax purposes. As such, the DST operative documents must contain significant restrictions on the DST’s ability to:
- Improve, lease, or finance the property
- Enter into material management or other agreements with respect to the property
- Acquire additional assets
- The OP acquires the property and enters into any desired leases, financings, and material agreements with respect to the property.
- The OP contributes the property to the DST, subject to such leases, financings, and agreements.
- The OP sells DST interests to investors seeking 1031 replacement property.
- The OP acquires a unilateral option to exchange its OP units for outstanding DST interests, exercisable approximately two years following the sale of the DST interests. Exercising this option would be treated as contributions of property by the DST holders in exchange for OP units, which would be expected to qualify for tax deferral by the DST holders (under Section 721 of the U.S. Tax Code). The receipt of OP units could not be achieved as part of the original exchange, as partnership interests are not qualifying replacement property.
The benefits of REIT DST 1031/721 exchanges
In addition to achieving the basic goal of facilitating a 1031 exchange, these exchanges can help address the potential disadvantages of standard 1031 exchanges:
- The DST investor would be a relatively passive investor without responsibility for the operation or management of the DST property.
- The DST investor could achieve diversification through the OP, following the exercise of the exchange option, provided that the OP owns a diversified portfolio of assets.
- A DST interest can be acquired in the exact dollar amount needed to satisfy a 1031 exchange. Additionally, assuming the exercise of the exchange option, the characteristics of the DST property should not be nearly as important as those of the overall OP portfolio.
In addition to the benefits mentioned, these exchanges can address the lack of liquidity inherent in most partnership investments, as REIT OP unit holders typically have the right to exchange their OP interests for REIT shares (generally a taxable transaction), which then can be sold or redeemed for cash.
The potential drawbacks of REIT DST 1031/721 exchanges
Despite their benefits, REIT DST 1031/721 exchanges involve some potential drawbacks, too, including the following:
- If the DST purchase and subsequent OP contribution somehow were “stepped together” for tax purposes, with the original exchange treated as an exchange of property for OP units, the exchange would fail to qualify as a 1031 exchange. Additionally, if the DST fails to be characterized as a disregarded entity (either at the outset or sometime subsequently), and instead is treated as a partnership, the same risk would exist.
- Following the OP contribution, the investor would be precluded from engaging in subsequent 1031 exchanges with the property it will then own (the OP units), which are not qualifying 1031 exchange property.
