Can You 1031 Exchange Into a REIT? The Complete Guide to UPREITs, 721 Exchanges, and DST to REIT Paths

Author: Gennaro Scibelli

The TL;DR Version

If you’ve wondered whether you can use a 1031 exchange to move an investment into a Real Estate Investment Trust (REIT), the short answer is no. REIT shares are securities and therefore do not qualify as replacement property under Section 1031. However, some investors may consider other structures, including a 721 UPREIT transaction or a 1031 exchange into a DST that may later become part of an UPREIT transaction (sometimes referred to as “DST bridges”).

Can You 1031 Exchange Into a REIT?

A real estate investor cannot 1031 exchange directly into shares of a REIT. A 1031 exchange allows an investor to defer recognition of gain, including capital gain and depreciation recapture, on the disposition of qualifying real property when the applicable requirements are met.

The investor must reinvest the proceeds into a like-kind property, meaning another real estate asset held for investment or business use. A 721 UPREIT structure is different rom a 1031 exchange. REIT shares are securities, and securities are excluded from Section 1031 treatment. A 1031 exchange also comes with strict requirements and timelines, including:

• Time Constraints: Precise deadlines for identifying (45 days) and purchasing (180 days) replacement properties.

• Like-Kind Requirements: Must be of similar nature or character, but not necessarily the same grade or quality.

• Investment Purpose: Properties must be held for investment or business purposes (excludes personal residences).

• Qualified Intermediaries: A 1031 exchange generally requires the use of a Qualified Intermediary, such as First American Exchange Company, to hold exchange funds and facilitate the transaction.

What is a REIT?

REITs allow investors to gain exposure to income-producing real estate without directly owning or managing the underlying property. These companies own or finance income-producing real estate across various sectors, providing dividends from real estate investments. By pooling funds from multiple investors, REITs make it possible to participate in large-scale real estate ventures.

A 721 UPREIT transaction, by contrast, involves contributing property to an operating partnership in exchange for operating partnership units. While REITS share diversification features with mutual funds, REITs are corporations or trusts that hold real estate and have distinct tax rules. Their structure allows income generation through property rentals and leases without managing physical properties. Many REITs are publicly traded on major stock exchanges (while others are public non-traded, or private), and liquidity varies by type. REITs must distribute at least 90% of their taxable income as dividends to maintain REIT status, typically ensuring steady income streams for shareholders. However, dividends are not guaranteed.

REITs offer several key potential investment characteristics that differ from direct real estate ownership and 1031 exchange strategies:

• Diversification: Exposure to various real estate sectors without direct ownership.

• Liquidity: Traded like stocks on major exchanges for easy buying and selling.

• Income Generation: Regular dividend payments (minimum 90% of taxable income).

• Professional Management: Expert oversight of property operations and acquisitions.

• Lower Barrier to Entry: Access to large-scale real estate investments with smaller capital requirements.

How Does a 721 UPREIT Work?

Attempting direct 1031 exchanges into REITs introduces legal complexities due to asset classification differences. Under §1031(a)(2), interests such as stocks, bonds, notes, and other securities (including REIT shares) are excluded from like-kind exchange treatment, so gain deferral is unavailable when acquiring REIT shares.

As a result, investors may consider the 721 UPREIT solution.

A 721 UPREIT (umbrella partnership real estate investment trust) transaction can provide a path for certain property owners to move from direct real estate ownership into an UPREIT structure on a tax-deferred basis.

This structure allows property owners to contribute their real estate assets to an UPREIT entity in exchange for operating partnership (OP) units, rather than REIT shares. The transaction is tax-deferred under Section 721 of the Internal Revenue Code, which is a separate non-recognition provision from the 1031 exchange.

So, what are some available paths to transition from a 1031 exchange to a 721 UPREIT?

1. Direct 721 Contribution: In a direct 721 contribution, an investor contributes appreciated real estate directly into a REIT’s operating partnership in exchange for operating partnership, or OP, units. A qualifying Section 721 contribution can defer recognition of gain at the time of contribution, but the operating partnership must be willing to accept the specific property.

2. 1031 to DST to 721 UPREIT: This approach starts with a traditional 1031 exchange into a Delaware Statutory Trust, allowing the investor to move from direct property ownership into fractional ownership of institutional real estate. In some programs, the DST property may later be contributed to an UPREIT operating partnership, with investors receiving OP units as part of the transaction. The timing and availability of that step depend on the specific program and structure.

3. DST Roll-up Into a Sponsor’s REIT: In a DST roll-up, the sponsor eventually contributes one or more DST properties into its affiliated REIT or operating partnership, and DST investors exchange their interests for OP units. This structure may provide a planned pathway from DST ownership into an UPREIT, but investors should understand the sponsor’s timing, holding restrictions, redemption terms, and the tax consequences of ultimately converting OP units into REIT shares or cash.

What Are the Benefits and Challenges of 721 UPREITs?

A 721 UPREIT structure may offer several potential advantages:

• Diversification: Access to institutional-quality properties across multiple markets.

• Income Potential: Many REITs and operating partnerships make regular distributions, although distributions are not guaranteed.

• Tax Deferral: A qualifying Section 721 contribution generally allows gain recognition to be deferred at the time of contribution.

• Professional Management: Freedom from direct property management responsibilities.

• Conversion Flexible: Depending on the structure, OP units may later be redeemable for REIT shares or cash, generally with tax consequences at that time.

• Estate Planning Benefits: Basis step-up upon death, potentially eliminating deferred gain for heirs.

However, investors should keep these risks in mind when considering 721 UPREIT exchanges:

• Market Fluctuations: Portfolio value can be affected by real estate market conditions.

• Concentration and Lock-Up Risk: 721 UPREIT structures may include holding-period or other restrictions to preserve tax protection, reducing flexibility to sell.

• Management Dependency: Success relies heavily on REIT management quality.

• Limited Control: Less direct influence over individual asset decisions.

Mistakes to Avoid With 721 UPREITs

In both 1031 exchanges and 721 UPREIT strategies, liquidity issues can arise. Investors should be aware of these frequent pitfalls:

• Missing Deadlines: For 1031 exchanges specifically, failing to adhere to 45-day identification and 180-day completion requirements.

• Inadequate Due Diligence: Not thoroughly researching replacement properties, REIT options or management teams.

• Same-Taxpayer: For a 1031 exchange, the taxpayer that disposes of the relinquished property must be the same taxpayer that acquires the replacement property, subject to applicable entity rules. A Section 721 contribution follows a different set of ownership and tax requirements.

• Poor Documentation: Incomplete or incorrect paperwork that can disqualify either 1031 or 721 UPREIT exchanges.

• Direct Fund Handling: Accessing exchange proceeds directly instead of using a Qualified Intermediary (in a 1031 exchange).

• Misaligned Goals: Choosing investments that don't match your long-term investment strategy.

• Insufficient Professional Guidance: Attempting complex transactions without experienced advisors.

Other REIT and 1031 tax considerations to keep in mind include:

• Ordinary Income Treatment: REIT Dividends are generally not treated as qualified dividends and are typically taxed at ordinary income rates, although individual investors may qualify for the Section 199A 20% pass through deduction. Portions of a REIT distribution may also be treated as capital gain dividends or return of capital.

• Potential for Higher Tax Rates: May result in a higher effective tax rate than capital gains.

• Unique Tax Treatment: Dividends are taxed in the calendar year they’re received (including reinvested amounts). Because dividends usually have no withholding, investors may need to make estimated tax payments during the year to avoid underpayment penalties.

Trust First American Exchange Company for Your 1031 Exchanges

First American Exchange Company serves as a Qualified Intermediary (QI) for 1031 exchanges nationwide. In that role, the QI holds exchange funds, prepares exchange documentation, and helps facilitate the transaction with the expertise to make a complex process simpler.

Contact our team to learn more about your options.