Can I 1031 Exchange into a REIT?
- By Zachary Kocurek, Exchange Advisor
- April 20, 2026
Table of Contents
Investors looking to diversify their real estate holdings while maintaining tax advantages often ask whether they can execute a 1031 Exchange directly into a Real Estate Investment Trust (REIT). The short answer is no; REIT shares are indirect ownership of real estate which means they do not qualify for like-kind property under IRS rules for 1031 Exchanges. However, there is an indirect path that can help you achieve similar diversification benefits while preserving your tax-deferred status. This strategy involves using a Delaware Statutory Trust (DST) as an intermediary step.
A DST qualifies as like-kind property under IRS regulations, making it eligible for a 1031 Exchange. After holding the DST investment for a suitable period, you can then convert it to operating partnership (OP) units in a REIT through a 721 Exchange, also known as an UpREIT (Umbrella Partnership Real Estate Investment Trust) transaction.* This two-step process allows you to transition from direct property ownership to a more diversified, passive REIT investment while continuing to defer capital gains taxes, offering a potential balance between diversification and tax deferral for certain investors.
*Disclaimer: Not all Delaware Statutory Trusts offer a 721 Exchange option into a REIT. Investors interested in eventually transitioning to REIT ownership must specifically select DSTs that include this feature in their offering documents.
How to Indirectly 1031 Exchange into a 721 UpREIT
The process of transitioning from direct property ownership to a REIT investment while maintaining tax deferral status requires the following key steps.
- Sell Your Existing Property: Work with a qualified intermediary to properly structure the sale of your investment property as part of a 1031 Exchange.
- Identify DST Investments: Within 45 days of selling your property, identify potential DST investments that qualify as replacement properties. Look specifically for DSTs that offer a 721 Exchange option, sometimes called UpREIT DSTs.
- Complete DST Purchase: Within 180 days of your property sale, complete your investment in the chose DST. This preserves your tax-deferred status through the initial 1031 Exchange.
- Hold the DST Investment: Maintain your DST investment for the long-term holding period specified in the offering documents, typically 5-10 years. This is a buy-and-hold strategy designed for patient investors seeking sustained tax deferral.
- Execute the 721 Exchange: When the DST sponsor exercises the conversion process, your DST interests can be exchanged for operating partnership (OP) units in the REIT’s umbrella partnership.
- Receive REIT Benefits: As an OP unit holder, you’ll receive distributions similar to REIT shareholders while continuing to defer capital gains taxes.
How Long Does the Process Take?
The timeline for a complete transition from direct property ownership to REIT investment through this two-step process spans several years.
- Initial 1031 Exchange: This follows standard 1031 Exchange timelines, 45 days to identify replacement DST properties and 180 days to complete the purchase.
- DST Holding Period: UpREIT DSTs generally fall into two categories – hardwired and hybrid UpREITS.
- Hardwired UpREITs: Typically, these DSTs have a fixed holding period of 2-3 years. After which, all investors who exchanged into the DST must participate in the UpREIT transaction, converting their DST interests into OP units.
- Hybrid UpREITs: Hybrid structures offer more flexiblity, with a typical hold period of 2-5 years. Investors can choose a cash purchase offer, enabling them to perform another 1031 Exchange or pay tax. Investors who opt not to receive cash proceeds are absorbed into the REIT.
- 721 Exchange Execution: The conversion from DST interests to OP units is generally a streamlined process once initiated by the sponsor, usually taking 30-60 days to complete.
From start to finish, expect the entire transaction to take several years. The longer timeline should be viewed as part of your long-term investment strategy rather than a quick portfolio adjustment.
How Does This Impact My Taxes?
The DST to UpREIT pathway creates significant tax advantages by establishing a continuous chain of tax-deferred transactions.
- Continued Tax Deferral: The initial 1031 Exchange into a DST defers capital gains and depreciation recapture taxes from your property sale. The subsequent 721 Exchange further defers those taxes when converting OP units.
- No Immediate Tax Recognition: Neither the 1031 Exchange nor the 721 Exchange triggers immediate tax liability if properly structured.
- Potential Step-Up in Basis: A major advantage of this strategy is the potential for a step-up in basis upon death, potentially eliminating capital gains tax liability for your beneficiaries and providing higher accessibility to liquidity.
Many UpREITs enhance this protection through tax protection agreements that prevent the operating partnership from selling the contributed property for a specified period, shielding investors from unexpected tax events. Beyond tax deferral, REIT operating partnerships typically own diverse property portfolios, providing more stable income streams with favorable tax treatment compared to direct property ownership, creating both immediate cash flow benefits and long-term tax advantages.
What Properties Qualify for a 721 Exchange?
To successfully execute this strategy, you need to understand what properties qualify at each stage.
For the initial 1031 Exchange:
- Relinquished property must be real property held for investment or business purposes
- Personal residences, inventory and property held primarily for sale do not qualify
For DST Investments:
- DSTs must own income-producing real estate
- DSTs must comply with IRS Revenue Ruling 2004-86, which establishes specific requirements for DSTs to qualify as “like-kind” property
- DST must have a 721 Exchange option in its offering documents if you plan to eventually convert to REIT OP units
For the 721 Exchange: The DST must contribute its property to a qualifying REIT operating partnership. The REIT must meet all regulatory requirements under IRC Section 856, and the transaction must follow the structural requirements of IRC Section 721. Working with experienced sponsors and advisors is essential to navigate these technical qualification requirements at each transition point.
Can a REIT Be Used for a 1031 Exchange?
REIT shares cannot be directly acquired through a 1031 Exchange because they are classified as securities, not real property. The IRS requires “like-kind” property in 1031 Exchanges, meaning real property must be exchanged for real property, and direct REIT investments simply don’t provide the required direct interest in real estate. However, two important distinctions make the indirect approach viable.
- DSTs as Intermediaries: Delaware Statutory Trusts do not qualify for 1031 Exchanges and can serve as an intermediary step toward REIT investment through a subsequent 721 Exchange.
- OP Units vs. REIT Shares: When completing a 721 Exchange, you receive operating partnership units, not publicly traded REIT shares. These OP units represent an interest in the partnership that owns the REIT’s properties, not shares in the REIT itself. This distinction is crucial for maintaining tax deferral.
REIT FAQs
Comparison: REIT vs. UpREIT
A standard REIT is a publicly traded entity that owns, operates or finances income-producing real estate, with shares trading on major exchanges, high liquidity, and a requirement to distribute at least 90% of taxable income to shareholders as dividends taxed as ordinary income. Importantly, direct REIT investment is not eligible for 1031 Exchanges. In contrast, an UpREIT (Umbrella Partnership REIT) uses a structure where properties are held in an operating partnership with the REIT as the general partner, allowing property owners to contribute properties in exchange for OP units, providing tax deferral benefits not available through direct REIT investment; while these OP units can often be converted to REIT shares, that conversion triggers taxation, whereas maintaining the OP units continues tax deferral through the 721 Exchange mechanism.
Where Do REITs Go on a Tax Return?
REIT investments create different tax reporting requirements depending on how you own them. Direct REIT shareholders receive Form 1099-DIV showing distributions, which they report on Schedule B for dividend income and Schedule D for any capital gains if shares were sold. For OP unit holders resulting from a 721 Exchange, the process is more complex. You’ll receive a Schedule K-1 reporting your share of partnership income, which requires more detailed tax reporting than direct REIT investment as different components of distributions may be taxed differently (ordinary income, return of capital, capital gains), making professional tax assistance particularly valuable for investors who have completed the DST to UpREIT transition.
What is the Tax Loophole for REITs?
REITs benefit from a significant tax provision that allows them to pay no corporate tax on income distributed to shareholders, effectively eliminating the double taxation that affects most corporate investments. This advantage requires REITs to distribute at least 90% of taxable income to shareholders, with that income then taxed at the individual shareholder level. For OP unit holders from a 721 Exchange, these tax advantages are further enhanced through continued deferral of original capital gains, no immediate taxation when receiving OP units, and potential estate planning benefits with a step-up in basis, creating a powerful combination of REIT tax benefits with 1031 and 721 Exchange benefits that sophisticated real estate investors can leverage for long-term wealth preservation.
What is the REIT Capital Gains Tax?
Capital gains taxation for REIT investments varies significantly based on your ownership structure. Direct REIT shareholders pay long-term capital gains rates (0%, 15% or 20% depending on income bracket) when selling shares held over one year, or ordinary income rates for shares held less than one year. However, OP unit holders from a 721 Exchange face a different scenario. Their original deferred gain remains untaxed until a triggering event occurs, such as selling OP units for cash, converting OP units to REIT shares (a taxable event), or when the partnership sells the contributed property (if not protected by a tax protection agreement), making the tax treatment substantially more favorable for investors who have utilized the DST to UpREIT strategy.
Is There a Downside to Investing in REITs?
The DST to UpREIT strategy comes with several important trade-offs that investors should carefully consider. Unlike direct property ownership, REIT investors surrender control over property management and investment decisions. OP units from a 721 Exchange typically have limited liquidity compared to publicly traded REIT shares, with many operating partnerships imposing restrictions on when and how many units can be redeemed. Tax reporting becomes more complex, as OP unit holders receive K-1s rather than 1099s. REIT values often show higher sensitivity to interest rate changes than direct real estate, and perhaps most significantly, once invested in OP units, you cannot use a 1031 Exchange for future investments, effectively closing the door on that strategy for the affected portion of your portfolio.
What is the 90% REIT Rule?
The 90% rule forms the foundation of the REIT tax structure, requiring these entities to distribute at least 90% of their taxable income to shareholders annually. This distribution requirement applies to the REIT itself rather than the operating partnership, ensuring income flows through to investors instead of accumulating at the corporate level, which enables the REIT to avoid corporate-level taxation. For OP unit holders who have completed a 721 Exchange, this rule creates a practical benefit in the form of regular cash distributions similar to what REIT shareholders receive, providing a reliable income stream while maintaining the tax-deferred status of the original investment, combining income generation with tax efficiency in a way few other investment structures can match.
How Do REITs Avoid Double Taxation?
REITs employ a specialized tax structure that bypasses the double taxation affecting most corporate investments by receiving a deduction for dividends paid to shareholders. By distributing at least 90% of taxable income, most REITs effectively eliminate corporate-level tax, with investors then paying tax on the distributions at their individual tax rates. For OP unit holders from a 721 Exchange, this efficiency is enhanced through the operating partnership structure, the partnership itself pays no tax, income “passes through” to unit holders, and the original capital gains remain deferred until a taxable event occurs, creating a remarkable tax-efficient investment vehicle for former property owners who have navigated the DST to UpREIT transition process.
What is the 5 and 50 Rule for REITs?
The “5 and 50” rule establishes that no more than 50% of a REIT’s shares can be held by five or fewer individuals during the last half of the taxable year, a provision designed to ensure broad ownership of REITs and prevent concentrated control of these tax-advantaged entities. For investors in the DST to UpREIT strategy, this rule generally poses few concerns as it applies to the REIT itself rather than to the operating partnership, and OP unit holders aren’t counted as direct REIT shareholders for this purpose; furthermore, the REIT sponsor typically monitors compliance with this requirement, allowing investors to focus on their investment objectives rather than regulatory technicalities.
Conclusion
While you cannot directly execute a 1031 Exchange into a REIT, the DST to UpREIT strategy offers a viable pathway to transition from active real estate ownership to passive REIT investment while preserving tax advantages. By first exchanging into a Delaware Statutory Trust and later converting to operating partnership units through a 721 Exchange, investors can defer capital gains taxes while gaining exposure to professionally managed, diversified real estate portfolios.
The key benefits of this approach include:
- Continued tax deferral of your original capital gains
- Professional management of your real estate investments
- Diversification across multiple properties and markets
- Reliable income streams through regular distributions
- Potential estate planning advantages with step-up in basis
This strategy requires careful planning, appropriate timing, and guidance from experienced advisors. For real estate investors seeking to simplify their holdings while maintaining wealth-building tax advantages, the DST to UpREIT approach represents one of the most effective transition strategies available in today’s market.
Remember that tax laws and investment structures evolve over time, so always consult with qualified tax and investment professionals before implementing any tax-deferred exchange strategy.
This material is provided for informational purposes only and does not constitute tax, legal or investment advice. Investments in DSTs and REITs involve risk and may not be suitable for all investors. Investors should consult their legal, tax and financial advisors before making any investment or exchange decisions.
About Real Estate Transition Solutions
Real Estate Transition Solutions (RETS) is a consulting firm specializing in tax-deferred 1031 Exchange strategies and Delaware Statutory Trust investment property. For over 26 years, we have helped investment property owners perform successful 1031 Exchanges by developing and implementing well-planned, tax-efficient transition plans carefully designed to meet their objectives. Our team of licensed 1031 Exchange Advisors will guide you through the entire process, including help selecting and acquiring passive management replacement properties best suited to meet your objectives. To learn more about 1031 Exchanges and Real Estate Transition Solutions, visit re-transition.com or call us at 888-755-8595.
As a 1031 Exchange Advisor at Real Estate Transition Solutions (RETS), Zachary Kocurek guides investment property owners through exchange processes and replacement options including DSTs and REITs. Holding Series 7, 22, 63 and 65 licenses, he combines his Master’s in Parks, Recreation and Tourism Sciences from Texas A&M with practical experience as a former Washington real estate agent and residential property investor to provide comprehensive investment guidance.
