Can You Perform a 1031 Exchange Into a REIT?

A 1031 exchange allows real estate investors to defer capital gains taxes, while Real Estate Investment Trusts (REITs) offer a way to invest in diversified portfolios of income-producing properties. Investors often wonder if a 1031 exchange can be used to acquire a REIT. This article clarifies the distinctions between real property and securities, exploring the viability of exchanging into REITs and the qualifying alternatives for tax-deferred real estate diversification.

Core Concepts of a 1031 Exchange

A 1031 exchange, or like-kind exchange, allows real estate investors to defer capital gains taxes when they reinvest proceeds from the sale of an investment property into another “like-kind” property. Internal Revenue Code Section 1031 outlines the conditions for this tax deferral. This provision applies to real property held for productive use in a trade or business or for investment.

The “like-kind” requirement refers to the nature or character of the property, not that properties must be identical. For example, an investor can exchange raw land for an apartment building, or a commercial property for an industrial one, if both are real property held for business or investment. Personal residences and properties held primarily for sale do not qualify. The deferral means the investor avoids immediate taxation, but the deferred gain is preserved in the basis of the new property, to be recognized upon a future taxable sale.

Timelines govern a 1031 exchange. Upon selling the relinquished property, the investor has 45 calendar days to identify potential replacement properties. This identification must be in writing and delivered to a qualified intermediary. The investor then has 180 calendar days from the sale date to acquire one or more identified replacement properties. Both deadlines must be met for a valid exchange.

Core Concepts of Real Estate Investment Trusts

Real Estate Investment Trusts (REITs) are companies that own, operate, or finance income-producing real estate. They allow individuals to invest in large-scale real estate portfolios without directly purchasing or managing properties. REITs specialize in various property sectors, such as office buildings, shopping malls, apartments, or self-storage facilities.

To qualify as a REIT, a company must meet requirements set by the IRS. These include investing at least 75% of total assets in real estate, cash, or U.S. Treasurys, and deriving at least 75% of gross income from real estate-related sources like rent or mortgage interest. REITs must distribute a minimum of 90% of their taxable income to shareholders annually through dividends. This allows REITs to avoid corporate income tax at the entity level, passing the tax obligation to shareholders.

REITs can be publicly traded on stock exchanges, public non-listed, or private. While most REIT dividends are taxed as ordinary income at the shareholder’s marginal tax rate, capital gains distributions and return of capital may receive different tax treatment. The structure provides investor access to real estate income and potential appreciation, making illiquid real estate more liquid.

The Challenge of Exchanging into Publicly Traded REIT Shares

A common question is whether a 1031 exchange can acquire shares in a publicly traded REIT. Despite REITs owning real estate, directly exchanging into publicly traded REIT shares does not qualify for tax deferral under Section 1031. The reason lies in the IRS’s interpretation of “like-kind” property.

Section 1031 requires an exchange of real property for other real property. Shares in a publicly traded REIT are considered securities, or personal property, not direct ownership of real estate. When an investor purchases REIT shares, they acquire an interest in the company that owns the real estate, not a direct ownership interest in the underlying physical properties. The Tax Cuts and Jobs Act of 2017 clarified that 1031 exchanges are limited exclusively to real property, excluding securities, stocks, bonds, and other financial assets.

This means that even though a REIT’s assets are real estate, the shares themselves do not meet the “like-kind” requirement. An investor holding REIT shares does not have direct claims, control, or legal rights over the individual real estate assets held by the REIT. Therefore, attempting a direct exchange from relinquished real property into publicly traded REIT shares results in a taxable event, triggering capital gains.

Qualifying Real Estate Investment Structures for 1031 Exchanges

While direct investment in publicly traded REIT shares does not qualify for a 1031 exchange, specific investment structures allow investors to achieve diversified real estate exposure while maintaining tax deferral. Tenants-in-Common (TIC) interests and Delaware Statutory Trusts (DSTs) are two structures recognized by the IRS as “like-kind” real property for exchange purposes. These structures enable multiple investors to hold fractional interests in large, income-generating commercial properties.

Tenants-in-Common (TIC)

TIC arrangements involve multiple individuals or entities directly co-owning an undivided fractional interest in a single piece of real property. Each co-owner receives a direct deeded title to their portion and shares pro-rata in the property’s income, expenses, and depreciation benefits. IRS Revenue Procedure 2002-22 outlines requirements for TIC interests to qualify for a 1031 exchange, including a limit of 35 co-owners and unanimous approval for major decisions. While TICs offer direct ownership, they can involve more active management and require individual loan underwriting for financing.

Delaware Statutory Trusts (DSTs)

DSTs represent a passive investment alternative that also qualifies for 1031 exchanges under IRS Revenue Ruling 2004-86. In a DST, investors acquire beneficial interests in a trust that owns and operates the real estate. This structure allows for a lower minimum investment, often starting around $100,000, and enables diversification across multiple properties. DSTs offer a hands-off approach, as a professional sponsor manages the property, handling all operational and management responsibilities.

DSTs are appealing for investors seeking passive income and a streamlined process, as the trust secures financing, and investors do not assume personal liability for property-level debt. DSTs operate under IRS guidelines, which limit the trustee’s ability to undertake certain actions like accepting new capital contributions or renegotiating loans after closing. Both TIC and DST structures allow investors to satisfy the “like-kind” requirement by providing direct or beneficial ownership interests in real property, making them suitable for tax-deferred exchanges.

Direct Acquisition of REIT Real Estate Assets

While purchasing shares of publicly traded REITs does not qualify for a 1031 exchange, a specific scenario involves a 1031 exchange directly into real estate assets owned by a REIT. This is distinct from acquiring REIT shares. It means an investor would purchase a property or portfolio of properties directly from a REIT entity. This transaction treats the REIT as a seller of real property, not an investment vehicle whose shares are being acquired.

Such an acquisition functions like any other direct real estate purchase for 1031 purposes, where the relinquished property is exchanged for like-kind real estate owned by the REIT. The transaction must adhere to all standard 1031 exchange rules, including the like-kind property requirement and timelines. This strategy is limited to institutional or very large individual investors due to the significant capital required to acquire entire real estate assets or portfolios from a REIT. It is not a common pathway for the average individual investor seeking to diversify real estate holdings.

Acquiring an entire REIT entity structured as a partnership or limited liability company (LLC) that directly owns real estate is another possibility. However, interests in partnerships are excluded from 1031 treatment, making this pathway narrow and subject to IRS scrutiny. For most investors seeking REIT-like exposure through a 1031 exchange, the focus remains on qualifying structures like DSTs and TICs.