Can You Do a 1031 Exchange Into a REIT?

A 1031 exchange allows real estate investors to defer capital gains taxes when they sell an investment property and reinvest the proceeds into a new, similar property. Real Estate Investment Trusts, or REITs, offer a way to invest in income-producing real estate through shares. Many investors wonder if they can combine these two strategies. While a direct 1031 exchange into traditional REIT shares is generally not possible, specific structures exist that enable investors to acquire an interest in real estate held by certain types of REIT-like entities.

Foundational Concepts of 1031 Exchanges and REITs

A 1031 exchange provides a mechanism for property owners to defer capital gains taxes on the sale of investment or business real estate. This deferral is achieved by reinvesting the sales proceeds into another “like-kind” property. The fundamental requirement is that both the property sold (relinquished property) and the property acquired (replacement property) must be real property held for productive use in a trade or business or for investment purposes.

Real Estate Investment Trusts (REITs) are companies that own, operate, or finance income-producing real estate across various property sectors. They allow individuals to invest in large-scale real estate portfolios without directly owning, managing, or financing properties. REITs are structured as corporations and issue shares to investors, similar to other public companies.

Investors in a REIT own shares in the company, which owns the real estate. These shares provide investors with a pro-rata share of the income produced by the REIT’s properties. REITs offer exposure to real estate, professional management, and liquidity.

Meeting the Like-Kind Requirement for REIT Investments

The “like-kind” requirement means the relinquished property must be exchanged for replacement property of the same nature. Traditional publicly traded REIT shares do not qualify as like-kind property for a 1031 exchange. The IRS considers these shares personal property, representing corporate ownership rather than a direct interest in real property.

Certain investment structures allow for a 1031 exchange into real estate interests similar to REITs. Delaware Statutory Trusts (DSTs) are a prominent example. A DST is a legal entity that holds title to real estate, allowing for passive, fractional ownership by multiple investors.

The IRS formally recognized DSTs as eligible replacement property for 1031 exchanges through Revenue Ruling 2004-86. This ruling clarifies that beneficial interests in a DST can be treated as direct interests in real property for 1031 purposes, provided the trust adheres to specific operational guidelines. These guidelines ensure the DST acts as a passive holder of real estate, with strict limitations on the trustee’s ability to vary investments, renegotiate leases, or engage in active business operations.

Umbrella Partnership Real Estate Investment Trusts (UPREITs) offer another path toward REIT investment through a 1031 exchange. While a direct 1031 exchange into UPREIT operating partnership (OP) units is not possible, a common strategy involves a two-step process. An investor first completes a 1031 exchange into a qualifying real estate interest, such as a DST.

After a suitable holding period for the DST, its sponsor may offer to convert the beneficial interests into OP units of an affiliated UPREIT through a Section 721 exchange. This 721 exchange allows for the tax-deferred contribution of the real property interest into the UPREIT’s operating partnership for OP units, providing an equity interest in a larger, diversified real estate portfolio.

Once a 721 exchange into UPREIT OP units occurs, the investor holds a security, not a direct interest in real estate. A subsequent 1031 exchange out of the UPREIT OP units back into real property is not possible. Tax deferral continues as long as the OP units are held, but selling them triggers a taxable event.

The Exchange Process for Qualifying REIT Structures

Executing a 1031 exchange into a qualifying REIT structure, such as a Delaware Statutory Trust (DST), requires specific procedural steps and strict IRS timelines. The process begins by engaging a Qualified Intermediary (QI) before the relinquished property’s sale. The QI is a neutral third party who facilitates the exchange and holds sale proceeds to prevent constructive receipt, which would disqualify the exchange.

Upon closing the relinquished property, proceeds transfer directly to the QI, not the investor. From this date, the investor has two deadlines. The first is the 45-day identification period, during which the investor must formally identify potential replacement properties in writing to the QI.

Identification must be unambiguous, typically including the property’s street address or a distinguishable name. Investors can identify up to three properties of any value, or any number of properties if their aggregate fair market value does not exceed 200% of the relinquished property’s value. Failure to meet this 45-day deadline results in a failed exchange, making the entire gain taxable.

Following the identification period, the investor has a second deadline: the 180-day exchange period. Within this timeframe, which runs concurrently, the investor must acquire one or more identified replacement properties. For DSTs, this involves purchasing beneficial interests in the trust using funds held by the QI.

The QI coordinates the replacement property acquisition, ensuring transaction documents align with 1031 exchange regulations. They facilitate the transfer of funds from the relinquished property’s sale directly to the replacement property’s seller, maintaining the tax-deferred exchange’s integrity. This process ensures IRS compliance, allowing investors to defer capital gains taxes on their real estate investments.