Can You 1031 Exchange Into a REIT? The DST-to-UPREIT (Section 721) Path
Investors who want to leave landlording but keep the tax deferral often ask if they can just exchange into a REIT. You can't, directly. But the industry built a path that gets you there in two steps, and it's become one of the most common exits for owners in their sixties and seventies. Here's how it works and what you give up.
- REIT shares are securities and are excluded from Section 1031. You cannot exchange a rental directly into a REIT.
- The two-step path: 1031 into a Delaware Statutory Trust sponsored by a REIT, then after a holding period contribute the DST interest to the REIT's operating partnership under Section 721 in exchange for OP units.
- The 721 contribution is tax-deferred but one-way. OP units cannot be exchanged under 1031 again; converting or selling them triggers the deferred gain.
- The DSTs I work with are zero-cash-flow structures; the UPREIT step is about diversification and liquidity, not monthly income.
Why you can't exchange directly into a REIT
IRC §1031(a)(2) excludes stocks, bonds, and other securities from like-kind treatment. A REIT share is stock. So is a partnership interest in a real estate fund. The exclusion is why a real estate investor who wants to diversify into a portfolio of hundreds of properties can't do it with a simple exchange.
Step one: 1031 into a DST
A Delaware Statutory Trust structured under Rev. Rul. 2004-86 holds real property, and a beneficial interest in it is treated as direct ownership of that property for §1031. So your rental can be exchanged into a DST interest in a normal deferred exchange, meeting the 45/180-day rules through a qualified intermediary. Many DSTs are sponsored by non-traded REITs specifically to serve as the on-ramp for step two.
Step two: the Section 721 contribution
After a holding period (typically two to three years, set by the sponsor and designed to support investment intent), the REIT's operating partnership offers to acquire the DST's property. You contribute your DST interest to the operating partnership under IRC §721, which allows tax-free contributions of property to a partnership in exchange for a partnership interest. You receive operating partnership units whose value tracks the REIT's shares. Your deferred gain carries into the OP units.
This 'UPREIT' structure (umbrella partnership REIT) has been used by public REITs since the 1990s to acquire property from owners who didn't want to trigger tax. The DST path just made it accessible to individual 1031 investors.
What you get
- Diversification. Your equity is now tied to a portfolio of dozens or hundreds of properties instead of one building.
- Liquidity, in pieces. OP units can usually be converted to REIT shares (or redeemed for cash) in increments, subject to the REIT's policies. Each conversion is a taxable event for that portion, so you can recognize gain on your own schedule.
- Estate simplicity. Units are easy to divide among heirs, and they receive a stepped-up basis at death like any other asset.
- No management. None.
What you give up
- The 1031 chain ends. OP units are partnership interests, excluded from §1031. Once you're in, the only ways out are a taxable conversion or the stepped-up basis at death.
- Control. You hold a passive interest in a company. The REIT decides what to buy, sell, and finance.
- Sponsor and REIT risk. Non-traded REIT share values are set by the sponsor's appraisals and liquidity is limited by the REIT's redemption program. Read the prospectus; ask how redemptions were handled in 2020 and 2022.
- Income expectations. The DSTs I work with are zero-cash-flow structures. The return comes from the tax you didn't pay, debt paydown, and value at exit, not distributions. The UPREIT step is a diversification and liquidity strategy for that equity.
Who it suits
Owners who are done with real estate operations, whose goal for the equity is preservation and eventual inheritance rather than income, and who want the ability to take taxable liquidity in small pieces over many years. It's a poor fit for investors who still want to buy buildings, because it closes the exchange door for good. If there's any chance you'll want to exchange again, stay in direct property or a DST that isn't part of a 721 program.
Frequently asked questions
Can I do a 1031 exchange into a REIT?
Not directly. REIT shares are securities and excluded from Section 1031. The available path is to exchange into a Delaware Statutory Trust and later contribute that interest to the REIT's operating partnership under Section 721.
What is a 721 exchange?
A contribution of property (or a DST interest) to a partnership, usually a REIT's operating partnership, in exchange for partnership units, with no gain recognized under Section 721. It is tax-deferred but ends your ability to do future 1031 exchanges with that equity.
How long do I have to hold a DST before the UPREIT step?
Sponsors typically require two to three years, both to support investment intent under Section 1031 and to satisfy the REIT's acquisition timeline.
Are operating partnership units taxable when converted to REIT shares?
Yes. Converting OP units to REIT shares, or redeeming them for cash, triggers recognition of the deferred gain on the portion converted. Units held until death receive a stepped-up basis.
Done managing property but not done deferring?
Let's talk about whether a DST, a DST-to-UPREIT path, or a simpler exchange fits what you want the equity to do.
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