Tax-advantaged real estate investments leverage the tax code to generate maximum after-tax returns for investors.

• A 1031 exchange is a tax-advantaged transaction following a provision in the tax code that permits real estate investors to defer capital gains taxes on the sale of real property by reinvesting the proceeds in like-kind real estate.

• A Delaware statutory trust (DST) is a legal entity allowing investors to acquire fractional ownership of real estate, without being responsible for the management of the real estate, in a structure that qualifies for Section 1031 exchange treatment.

DSTs offer investors limited liability, asset protection and confidentiality.

Benefits of DST Investment

• Tax deferral with potential tax forgiveness to heirs (step up in tax basis on death)

• Access to investment-grade real estate investors may not otherwise be able to afford

• Ability to diversify a singular investment into multiple properties to reduce risk

• A pipeline of qualifying replacement properties where due diligence has already been completed and debt is in place to satisfy Section 1031 debt rules

• Passive income with a sponsor providing all needed services

• Benefits of real estate ownership, including depreciation deductions, bonus depreciation and cost segregation to shelter distributions

• A largely automated, simplified closing process

DSTs have a life cycle of only five to 10 years.

When a DST reaches maturity (going “full cycle”), an investor has a choice. Choosing to continue the investment through another 1031 exchange or a 721 exchange maximizes the tax-deferral benefits. Cashing out triggers an immediate taxable event.

• A Section 721 exchange is a tax-advantaged transaction following a provision in the tax code that permits real estate owners (including DST owners) to contribute their property to the operating partnership of a real estate investment trust in exchange for interests in that partnership on a tax-deferred basis.

• A real estate investment trust (REIT) is a company that invests in income-producing real estate by pooling the capital of many investors to purchase and operate a portfolio of investment-grade real estate.

Section 721 – similar to Section 1031 governing real estate exchanges – is a popular alternative to a taxable sale for real estate owners interested in a tax-favored investment with institutional management.

Benefits of a REIT Investment

• Tax-advantaged income

• Reduced portfolio risk because the operating partnership owns a large portfolio of real estate

• Geographic diversification

• Passive income, without having to actively participate in the real estate business

• Professional management that maximizes shareholder value through management expertise and operating efficiencies at scale

• Increased transparency with additional oversight by independent directors, analysts and third-party auditors

• Permanent tax deferral (unlike a DST) with tax forgiveness on death

• Future liquidity potential

• Operating partnership (OP) units can be divided up for family gifting and estate planning

1031 to 721 Exchange/UPREIT Highlights

While a DST enables fractionalized ownership of a single investment-grade property, a REIT enables ownership in a portfolio of investment grade properties, allowing for greater diversification and growth potential.

By choosing to move forward with a DST-to-UPREIT transaction, an investor:

• Already understands the quality of the new DST assets being added to the REIT

• Continues their tax-advantaged investment

• Minimizes closing costs, such as qualified intermediary (QI) fees

• Enjoys a simplified electronic closing process

• Avoids the hassles of satisfying the Section 1031 debt requirement

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This article originally appeared on Capital Square's website.