Can You 1031 Exchange Into a REIT? Yes With a Twist

Real estate investors often find themselves asking, “Can I use a 1031 exchange to invest in a REIT?” The short answer is no—but don’t close the door just yet. While a direct 1031 exchange into a REIT isn’t possible under current IRS rules, there’s a savvy, IRS-approved workaround that allows you to enjoy the benefits of REIT ownership without sacrificing the tax advantages of a 1031 exchange.

Welcome to the world of Delaware Statutory Trusts (DSTs) and the 721 exchange, also known as UPREIT (Umbrella Partnership Real Estate Investment Trust). Together, this dynamic duo offers a powerful solution to real estate investors seeking diversification, preservation of wealth, and potential liquidity.

Why You Can’t Use a 1031 Exchange Directly for a REIT

A 1031 exchange allows you to sell investment property and reinvest the proceeds into a “like-kind” property, deferring capital gains taxes in the process. However, there’s a catch when it comes to REITs.

Under IRS guidelines, “like-kind” property must be real property, such as land or buildings. REIT shares, on the other hand, are considered personal property, not real property. This classification disqualifies REITs from being eligible for a direct 1031 exchange.

But where there’s an IRS restriction, there’s often a solution. Enter the DST and 721 exchange strategy.

The DST Workaround Your Bridge to a REIT

The Delaware Statutory Trust (DST) is a legal entity that owns institutional-grade real estate, such as multifamily buildings, office spaces, or industrial warehouses. Investors can purchase fractional interests in the DST that qualify as “like-kind” property under 1031 exchange rules.

Here’s where the twist comes in. Some DSTs are specifically designed to serve as a stepping stone to REIT ownership through a 721 exchange. These DSTs, often called “721-compatible DSTs” or “bridge DSTs,” create a pathway for investors to convert their DST interests into operating partnership (OP) units in a REIT.

This offers an opportunity to eventually hold assets in a REIT without triggering capital gains taxes.

How It Works From 1031 to DST to REIT

Here’s a step-by-step breakdown of how this strategy works in practice.

1. Sell Your Property and Complete a 1031 Exchange Into a DST

Start by selling your investment property and completing a 1031 exchange into a qualifying DST. Since DST interests qualify as real property, this transaction allows you to defer your capital gains taxes.

2. Hold Your DST Interest

To satisfy IRS safe harbor guidelines, DSTs typically require a two-year minimum holding period. During this time, you’ll earn passive income generated by the assets held in the DST.

3. Execute a 721 Exchange Into a REIT

After the holding period, you may have the option to convert your DST interest into operating partnership (OP) units in a REIT through a 721 exchange. These OP units are often economically equivalent to REIT shares. This step allows you to enjoy the benefits of REIT ownership without losing your deferred tax status.

Why Investors Choose the DST to UPREIT Path

The DST-to-UPREIT strategy offers several compelling advantages, making it a popular choice among real estate investors.

1. Tax Deferral

By moving from your original property to a DST through a 1031 exchange, you defer capital gains taxes. The subsequent 721 exchange allows you to maintain this deferral while achieving REIT ownership.

2. Passive Income

Managing real estate can be time-consuming and stressful. With REITs, you can enjoy regular dividend payments without the headaches of property management.

3. Estate Planning Made Simple

REIT shares or OP units can be passed on to heirs with a step-up in tax basis, potentially eliminating deferred taxes entirely. This makes the DST-to-REIT route an attractive option for those looking to simplify estate planning and preserve wealth for future generations.

4. Liquidity Options

Unlike traditional real estate or DSTs, REITs bring an added level of flexibility. Selling real estate often takes months, but with REIT shares, you have the option to sell anytime in the public market, offering improved liquidity and exit strategies.

Not All DSTs Are Created Equal

If your ultimate goal is to transition into a REIT, choosing the right DST is critical. Not all DSTs are designed for a 721 exchange, so you’ll need to do your due diligence.

Here’s What to Look For

• 721 Compatibility

Ensure the DST is structured with an UPREIT strategy in mind. These are usually sponsored by the REIT you’ll transition into.

• Transparent Terms

The sponsor should provide clear guidelines on the timing, process, and expectations for executing the 721 exchange.

• Reputable Sponsors

Work with DST sponsors and REITs with a proven track record of successful transitions and investor-friendly practices.

Final Thoughts The Golden Bridge to REIT Ownership

The ability to transform a 1031 exchange into REIT ownership—with tax deferral intact—is an exciting option that offers unparalleled flexibility. The DST-to-UPREIT pathway is perfect for those seeking diversified investments, passive income, estate planning advantages, and liquidity options.

However, remember that not all DSTs are suited for this strategy. It’s crucial to consult experienced professionals who understand the nuances of both 1031 exchange rules and REIT structures to ensure your investments align with your goals.

If you’re interested in learning more about 721-compatible DSTs or the DST-to-REIT strategy, get in touch! Contact us at solution@medalistreit.com to see if this powerful combination is the right fit for your financial future.