Can You 1031 Exchange Into a REIT? The Short Answer and the Two Workarounds

Many property owners reach a point where they would like the simplicity of a real estate investment trust: professional management, diversification and, for listed REITs, the ability to sell shares quickly. Naturally, they ask whether they can 1031 exchange their building into REIT shares.

The short answer is no. REIT shares are stock, and stock is not like kind to real property. Exchange proceeds cannot be used to buy them directly without the transaction becoming taxable.

There are, however, two established routes that can lead to REIT ownership while deferring tax. Both involve trade offs worth understanding before you start.

Why can a 1031 exchange not buy REIT shares?

Since 2018, Section 1031 applies only to real property. Shares of a REIT, whether listed or non traded, are securities representing ownership of a company that owns real estate. They are not interests in real property for exchange purposes.

If an intermediary used exchange funds to buy REIT shares, the exchange would fail and the gain would be taxable.

Workaround one: exchange into a DST, then convert

The most common route has two steps.

Step one. Exchange into a Delaware Statutory Trust interest. DST interests are treated as interests in real property, so the exchange defers the gain.

Step two. Later, the DST's property is contributed to a REIT's operating partnership under Section 721, in exchange for operating partnership units. That contribution is generally not taxable.

Investors end up holding operating partnership units, which are economically linked to the REIT and can often later be converted into REIT shares.

Workaround two: contribute property directly

Owners of properties a REIT wants to acquire can sometimes contribute their property directly to the REIT's operating partnership in exchange for units, without a DST in between. This is usually available only for larger, institutional quality properties.

What do you give up with either route?

Future 1031 exchanges. Operating partnership units are partnership interests, not real property. They generally cannot be exchanged under Section 1031. Your chain of exchanges ends.

Tax deferral on conversion or redemption. Converting units into REIT shares, or redeeming units for cash, is generally a taxable event. The deferred gain from your entire exchange chain can become taxable at that point.

Control over timing. In DST programmes designed for 721 conversion, the sponsor or REIT may hold an option to acquire the property, so the conversion may happen when they choose.

Protection from partnership events. Actions inside the operating partnership, such as selling the property you contributed or reducing debt allocated to you, can sometimes trigger tax.

When does the REIT route make sense?

For investors who are confident they are finished with direct real estate and intend to hold until death, the route can work well. Heirs may receive a step up in basis on the units, reducing or eliminating the deferred gain, and units are often easier to divide than property.

It makes less sense for investors who may want to buy property again, who need to access capital during life, or who value the flexibility of continued exchanges.

How do DSTs and REITs compare as direct investments?

A DST owns a specific property or small group of properties, has a defined hold period, provides no control, and is illiquid. A REIT owns a larger portfolio, has no fixed end, and ranges from highly liquid listed shares to non traded structures with limited redemptions. Only the DST can receive 1031 proceeds directly.

What should you ask before choosing the REIT route?

• ›Does the DST include an option for a REIT to acquire its property?
• ›Can investors decline conversion to units?
• ›How liquid are the units and any REIT shares they convert into?
• ›Are there tax protection provisions for contributors?
• ›What fees apply at each stage?

What does the path look like over time?

A typical sequence might run like this. In year one, an investor sells a rental and exchanges into a DST interest. In year three, the DST's property is contributed to a REIT's operating partnership and the investor receives units. From then on, the investor receives distributions on the units and holds them.

If the investor later redeems units for cash or converts them into shares and sells, tax becomes due on the deferred gain from the whole chain. If the investor holds the units until death, heirs may receive a step up in basis. The timing of that final step drives most of the tax outcome.

Are there alternatives that keep flexibility?

Yes. Investors who want passive ownership without ending their exchange chain can stay in DSTs that do not include a conversion feature, exchanging from one DST into another when each property sells. Others choose net lease property with a single corporate tenant. Both keep future 1031 exchanges available, at the cost of less liquidity than a listed REIT.

What to do first

Decide whether you want to keep exchanging or whether this is likely to be your final real estate decision. If it is final, model the tax on holding units until death versus redeeming them during life. If it is not, keep your options open with direct property or DSTs without a conversion feature.

Nothing here is tax, legal or investment advice. DST and REIT interests are securities offered through licensed broker dealers and definitive offering documents, and investing involves risk including loss of principal. Confirm your plan with your advisers.