What if you could trade the late-night phone calls and landlord duties for the passive income and diversification of a REIT, all without writing a massive check to the IRS? It’s a goal many property owners share, but most assume it’s impossible because a direct swap is off the table. While you can’t exchange your building for REIT shares in one move, a structured, multi-step process can get you there. This strategy uses a Delaware Statutory Trust (DST) as the crucial link between your 1031 exchange and your final investment. Think of it as a strategic detour that keeps your tax deferral intact. This article is your roadmap to understanding this powerful reit 1031 exchange strategy, from the initial sale to the final conversion.

Key Takeaways

• Know the "Like-Kind" Rule: A 1031 exchange requires swapping real property for other real property. Because the IRS classifies REIT shares as securities (personal property), you cannot exchange your investment property directly for them, making a multi-step strategy essential.
• Use a DST as the Middle Step: The established path involves two tax-deferred transactions. First, you complete a 1031 exchange from your property into a Delaware Statutory Trust (DST). Later, you may have the opportunity to convert that DST interest into REIT shares through a separate 721 exchange.
• Plan for a Permanent Strategy Shift: Moving into a REIT is a final step that ends your ability to perform future 1031 exchanges with that capital. You must weigh the benefits of diversification and passive income against the loss of future tax-deferral options and the eventual tax bill you'll face when you sell the shares.

What Is a 1031 Exchange and How Does It Work?

If you’re a real estate investor, you’ve likely heard of the 1031 exchange. In simple terms, a 1031 exchange lets you sell an investment property and buy another "like-kind" investment property without paying capital gains taxes on the sale right away. Think of it as a strategic swap that allows you to defer the tax bill and keep your money working for you.

This powerful tool, named after Section 1031 of the U.S. Internal Revenue Code, is designed to help investors grow their portfolios. Instead of losing a chunk of your profit to taxes after a sale, you can roll the entire amount into a new, potentially more valuable or better-performing property. For savvy sellers, it’s a way to transition between investments, change property types, or move into new markets without an immediate tax hit. But to make it work, you have to follow some very specific rules, especially when it comes to what you buy and when you buy it.

How a 1031 Exchange Defers Taxes

The key word to remember with a 1031 exchange is "defer." You aren't avoiding taxes forever, but you are postponing them. When you sell an investment property, you typically owe capital gains tax on the profit. With a 1031 exchange, you can defer that payment by reinvesting the proceeds into a new property. This allows you to use the full value of your sale to acquire your next asset, giving you more buying power. You can continue to do this from one property to the next, allowing your investment to grow on a tax-deferred basis over time. The tax obligation only comes due when you finally sell a property for cash without rolling it into another exchange.

What Qualifies as a "Like-Kind" Property?

The term "like-kind" can be a little misleading. It doesn't mean you have to exchange an apartment building for another apartment building. The rules are actually quite flexible. The main requirement is that you must swap one piece of real property held for investment or business use for another. For example, you could exchange a piece of raw land for a commercial office building or a single-family rental for a multi-unit complex. The properties just need to be of the same nature or character. The catch is that this rule applies strictly to real property. Things like stocks, bonds, and REIT shares are considered personal property, not real property, so they don't qualify for a direct exchange.

Key Timelines You Can't Miss

The 1031 exchange process is governed by strict and non-negotiable deadlines. Once you sell your original property, the clock starts ticking. First, you have 45 days to formally identify potential replacement properties. This must be done in writing and submitted to a qualified intermediary—the third party who holds your funds during the exchange. After you’ve identified your targets, you have a total of 180 days from the date of the original sale to close on the purchase of one or more of those properties. Missing either of these deadlines will disqualify the entire exchange, and you’ll be on the hook for the capital gains taxes. That’s why it’s so important to start looking at available listings and have a plan in place before you even sell.

Can You Directly Exchange Real Estate for REIT Shares?

So, you've sold an investment property and are looking to roll those gains into something new using a 1031 exchange. You might be wondering if you can move that money directly into a Real Estate Investment Trust (REIT) to diversify and simplify your holdings. It’s a smart question that many investors ask, but the short answer is no. Unfortunately, you cannot directly use a 1031 exchange to invest in a REIT.

The reason comes down to a critical IRS rule about what qualifies for this tax deferral. For a 1031 exchange to be valid, you must swap one investment property for another of a “like-kind.” While it seems logical that a rental property and a share in a company that owns hundreds of properties would be similar enough, the IRS views them as two fundamentally different types of assets. One is classified as real property, and the other is personal property. This distinction is the main hurdle, but it doesn't mean your goal is out of reach. There's a well-established strategy involving a special vehicle called a Delaware Statutory Trust (DST) that can bridge this gap, which we'll explore in detail.

Why REITs Aren't Considered "Like-Kind" Property

The term "like-kind" can be a bit misleading. It doesn’t mean you have to exchange an apartment building for another apartment building. You could exchange it for raw land or a commercial office space. The key is that both properties must be considered real property held for investment or business use. The IRS does not consider REIT shares "

How the IRS Classifies Real vs. Personal Property

To understand the "like-kind" rule, it helps to know how the IRS draws the line between real and personal property. For a 1031 exchange, you must swap one piece of real property—like a building or land—for another. This is a direct ownership interest. In contrast, shares in a REIT are considered personal property, similar to stocks or bonds. Even though the REIT itself owns a portfolio of real estate, your shares represent an ownership stake in the company, not the physical properties. Because REIT shares are seen as "personal property," they don't qualify for a like-kind exchange with actual real estate.

What Are Delaware Statutory Trusts (DSTs)?

If you've been exploring 1031 exchanges, you've likely come across the term Delaware Statutory Trust, or DST. Think of a DST as a legal framework that allows a group of investors to pool their money and collectively own one or more large, high-quality commercial properties. A trustee manages the property on behalf of all the investors, who are the "beneficial owners."

This structure is a game-changer for real estate investors, especially those looking to complete a 1031 exchange without the headache of finding and managing a new property on their own. It opens the door to owning a piece of institutional-grade real estate that might otherwise be out of reach for an individual investor. Instead of buying another fourplex, you could own a fractional interest in a major apartment complex or a commercial building.

Why DSTs Qualify for a 1031 Exchange

So, what makes a DST the perfect vehicle for a 1031 exchange when a REIT isn't? It all comes down to how the IRS sees the investment. The IRS considers an interest in a DST to be a direct interest in real estate. This means it qualifies as a "like-kind" property, which is the fundamental requirement for a tax-deferred exchange. You are essentially trading your old property for a fractional interest in a new one.

This is the key difference between a DST and a REIT. When you buy into a REIT, you're buying shares in a company that owns real estate—the IRS views this as personal property, not real property. Because a DST gives you direct ownership, it allows you to defer those capital gains taxes and keep your money working for you in another real estate investment.

The Benefits of DST Ownership

Investing in a DST offers many of the same perks as a REIT but is specifically designed to comply with 1031 exchange rules. One of the biggest advantages is diversification. Instead of putting all your capital into a single replacement property, a DST often holds a portfolio of multiple properties across different locations or asset classes. This helps spread out your risk.

Another major benefit is the potential for passive income without the responsibilities of being a landlord. The property is managed by a professional sponsor, so you don't have to deal with tenants, toilets, or trash. For many sellers looking to transition away from active management, this hands-off approach is exactly what they need. You can collect income while someone else handles the day-to-day operations.

The Advantage of Professional Management

The professional management baked into a DST structure is a huge draw. These properties are overseen by experienced real estate firms, or "sponsors," who handle everything from acquisitions and financing to property management and eventual sale. This level of expertise can provide access to higher-quality properties and more sophisticated management strategies than most individual investors could achieve on their own.

It's also important to note that DSTs are typically private investments, meaning they aren't traded on public stock exchanges like most REITs. This makes working with a trusted team essential. Having expert guidance helps you vet the sponsor and the underlying properties to ensure the investment aligns with your financial goals.

How to Use a DST to Invest in a REIT

So, you can't swap your investment property directly for REIT shares in a 1031 exchange. But that doesn't mean it's impossible to get there. Think of it as a strategic detour. By using a Delaware Statutory Trust (DST) as a middle step, you can successfully move from a directly-owned property into a REIT while keeping your tax deferral intact. This approach requires a bit of planning, but it’s a well-established path for investors looking for diversification and passive income without an immediate tax hit.

The Two-Step Strategy: From 1031 to DST to REIT

The process involves two key exchanges. First, you sell your investment property and perform a standard 1031 exchange into a DST. The IRS considers an interest in a DST to be "like-kind" to real estate, making this a valid move to defer your capital gains taxes. You’re essentially trading one property for a fractional interest in a portfolio of properties. The second step happens later, when the DST sponsor might offer to convert the trust into a REIT. This allows you to transition from the DST into REIT ownership, completing your investment goal.

What Is a 721 Exchange?

The magic that turns your DST into a REIT is called a 721 exchange. When a DST sponsor decides to absorb the trust into a larger REIT, you have the option to swap your DST interest for shares in the REIT's operating partnership, often called OP Units. This transaction is governed by Section 721 of the tax code, which allows you to make the conversion without triggering an immediate tax event. A 721 exchange lets you continue deferring taxes as you move into a more liquid and diversified asset, effectively completing the second leg of your journey.

Planning Your Conversion Timeline

Patience is key with this strategy. The conversion from a DST to a REIT isn't immediate. You should plan on holding your DST interest for several years before a potential REIT conversion opportunity arises. This timeline allows the DST to operate and mature, and it gives the sponsor time to execute their larger business plan. For many investors, this holding period is a worthwhile trade-off. It allows you to defer taxes on gains and depreciation recapture from the sale of your original property while positioning yourself for a future in a professionally managed REIT. If you're considering this path, the first step is understanding your current property and planning your sale with one of our seller's guides.

Your Step-by-Step Guide to This Investment Strategy

While you can't swap your property directly for REIT shares in a single move, there is a well-established strategy to get there. Think of it as a multi-step journey that allows you to transition from direct property ownership to fractional ownership in a diversified portfolio, all while deferring capital gains taxes along the way. This process requires careful timing and a solid team of professionals, but breaking it down into clear steps makes it much more manageable. Here’s exactly how it works, from selling your property to holding REIT shares.

Step 1: Sell Your Original Property

The entire process begins when you sell your investment property. But this isn't a typical sale where the proceeds land in your bank account. To comply with 1031 exchange rules, you must work with a Qualified Intermediary (QI) from the start. The QI is a neutral third party that will hold your sale proceeds in escrow. This is a critical step because if you take personal control of the funds, even for a moment, the transaction is disqualified, and your tax deferral is lost. Your QI will safeguard the funds and ensure they are properly transferred to the next investment, keeping your exchange compliant with IRS regulations.

Step 2: Find and Invest in a DST

With your funds securely held by the QI, your next move is to identify and invest in a Delaware Statutory Trust (DST). Within 45 days of your property's sale, you must formally identify potential replacement properties, and a DST is an excellent option. The IRS considers a beneficial interest in a DST to be a "like-kind" property, making it an eligible replacement for your 1031 exchange. You have a total of 180 days from the sale date to close on the replacement property, which in this case means using the funds held by your QI to purchase an interest in the DST.

Step 3: Convert Your DST into a REIT

This is the key step that connects your 1031 exchange to a REIT. Many DSTs are structured with a future plan to be acquired by a larger REIT. When this happens, the REIT doesn't buy your DST interest for cash. Instead, it acquires the entire trust through a process called a 721 exchange, also known as an UPREIT transaction. In this exchange, you trade your interest in the DST for operating partnership (OP) units in the REIT. This is another tax-deferred exchange, meaning you continue to postpone capital gains taxes. You now own a piece of a diversified REIT portfolio instead of an interest in a single trust.

Step 4: Work with a Qualified Intermediary

Navigating a 1031 exchange, a DST investment, and a 721 conversion is complex. It’s absolutely essential to have a team of experts guiding you. Your Qualified Intermediary is non-negotiable for handling the exchange itself, but you should also consult with your tax advisor and legal counsel to understand all the implications. They will ensure every transaction is structured correctly and aligns with your long-term financial goals. Having a knowledgeable real estate professional on your side can help you find the right opportunities and coordinate the process. If you're considering this path, our team is here to help you get started.

What Are the Tax Implications of Converting to a REIT?

While using a DST to move into a REIT can be a smart way to diversify your portfolio and step back from active management, it’s a decision with major financial ripple effects. This isn't just another transaction; it's a fundamental shift in your investment strategy that changes how your money is taxed and what you can do with it down the road. Before you make the leap, it’s critical to understand exactly what you’re signing up for, from losing future tax deferral options to facing a significant tax bill when you eventually sell. This move requires careful planning with your financial and legal advisors to ensure it aligns with your long-term goals.

You Lose Future 1031 Exchange Options

The biggest trade-off you make in this process is giving up the ability to do another 1031 exchange with this capital. Once your investment is converted into REIT shares through a 721 exchange, that’s it. You can’t roll those funds into another property to defer taxes again. Why? Because the IRS views real estate and REIT shares differently. A 1031 exchange requires swapping for a “like-kind” property”, and REIT shares are considered securities (personal property), not real property. This move is a one-way street, so you have to be certain that the benefits of REIT ownership outweigh the powerful tax advantages of continuing with 1031 exchanges.

Understanding the Deferred Tax Bill

Remember, a 1031 exchange is tax-deferred, not tax-free. That deferred tax liability doesn't just disappear when you convert to a REIT—it’s simply waiting. When you eventually decide to sell your REIT shares, the full tax bill comes due. And it can be substantial, especially if you’ve been deferring gains for years. This single payment will likely include federal and state capital gains taxes, a 25% tax on all the depreciation you’ve claimed over the years (known as depreciation recapture), and potentially a net investment income tax. It’s essential to plan for this eventual tax event with your financial advisor so you aren't caught by surprise.

How This Affects Your Estate Plan

This strategy also has a significant impact on your estate plan and what you pass on to your heirs. When you own real estate directly, your heirs typically receive a "step-up in basis" to the property's fair market value at the time of your death. This can wipe out the capital gains tax liability on a lifetime of appreciation. While REIT shares can also receive a step-up in basis, your heirs inherit shares, not property. They lose the ability to continue deferring taxes by rolling the investment into another property via a 1031 exchange. This decision shapes your legacy, so it’s crucial to discuss the long-term implications with your family and estate planning professionals.

Weighing the Pros and Cons

This investment strategy has some compelling benefits, but it’s not the right fit for everyone. Like any major financial decision, it comes with its own set of advantages and risks that you need to consider carefully. Understanding both sides of the coin is the first step to figuring out if using a DST to invest in a REIT aligns with your long-term goals. Let’s break down what you stand to gain and what you’ll have to give up.

Pro: Diversify Your Portfolio and Earn Passive Income

One of the biggest draws of this strategy is the ability to generate income without the day-to-day headaches of being a landlord. By investing in a DST and eventually a REIT, you can collect returns from a wide range of properties without ever having to manage them directly. This approach allows you to diversify your holdings across different asset types and geographic locations, which can help spread out your risk. Instead of having all your capital tied up in one or two buildings, you become a fractional owner in a much larger, professionally managed portfolio. It’s a great way to transition from active property management to a more passive investment role.

Con: Face Limited Liquidity and Market Risk

A major trade-off for that passive income is a lack of liquidity. Unlike publicly traded stocks, shares in many private or non-traded REITs can’t be sold quickly or easily. If you suddenly need access to your capital, you might find it’s tied up for a significant period. This illiquidity can become a serious issue, especially if the market takes a downturn and you want to shift your strategy. You’re essentially locked into the investment for the long haul, so you need to be comfortable with not having immediate access to your funds and riding out any market volatility.

Con: Give Up Direct Control of the Property

If you’re used to making all the decisions for your properties, this strategy requires a big shift in mindset. When you exchange your property for shares in a DST or REIT, you hand over the reins to a management team. You no longer have a say in tenant selection, property improvements, or when to sell. For many hands-on investors, giving up this control can be difficult. It’s also critical to remember that once you complete a 721 exchange into a REIT, you can’t use that capital for another 1031 exchange down the line. This move permanently ends your ability to defer taxes on that capital through future like-kind exchanges, limiting your flexibility.

Con: The REIT Conversion Isn't Guaranteed

The entire strategy hinges on the DST eventually converting into a REIT, but that outcome is never a sure thing. Not all DSTs are structured with a clear path to a REIT conversion, and even if a plan exists, market conditions or other factors could prevent it from happening. There’s no guarantee the conversion will occur or that it will happen on your preferred timeline. This uncertainty adds a layer of risk. It’s why working with a team of trusted professionals is so important—they can help you vet the DST sponsor and analyze the real probability of a successful conversion.

Common Myths About 1031 Exchanges and REITs

The strategy of using a 1031 exchange to move into a REIT through a DST is a sophisticated one, and with that comes a lot of confusion and misinformation. It’s a powerful tool for investors looking to transition from active property management to passive income, but it’s crucial to separate fact from fiction. Let’s clear up some of the most common myths so you can make informed decisions about your investment portfolio. Understanding these nuances is key to successfully managing your real estate assets and planning for the future.

Myth: You Can Directly Exchange into a REIT

This is probably the biggest misconception out there. You cannot sell your investment property and directly buy shares in a REIT as part of a 1031 exchange. The reason is simple: the IRS has strict rules about what qualifies as a "like-kind" property. A 1031 exchange requires you to swap real property for other real property. REIT shares, on the other hand, are considered personal property, like stocks. Because they aren't "like-kind," a direct swap is not allowed and would trigger a taxable event. This is why the Delaware Statutory Trust (DST) is such a critical piece of the puzzle for sellers looking to make this transition.

Myth: The DST to REIT Conversion Is a Sure Thing

While the DST is the vehicle that makes a future REIT investment possible, the conversion itself is not guaranteed. Some investors assume that every DST will eventually convert into a REIT, but that isn’t the case. Many DSTs are designed to simply hold and manage properties for a set period before selling them. Only certain DSTs are structured with a potential UPREIT transaction (a 721 exchange) in mind. Even then, market conditions or other factors could prevent the conversion from happening. It's essential to work with experienced professionals and carefully vet the DST sponsor and their track record before investing. You need to understand the specific plan and likelihood of a REIT conversion for any DST you consider.

Myth: It's Easy to Cash Out and Avoid Taxes

The DST-to-REIT strategy defers taxes, it doesn't eliminate them. Once you complete the 721 exchange and your DST interest becomes REIT shares, you’ve stepped out of the 1031 exchange world for good with that capital. You can no longer perform another 1031 exchange with those funds. When you eventually decide to sell your REIT shares, all of the capital gains taxes you’ve deferred over the years—potentially from multiple exchanges—will come due. This can result in a significant tax bill. Before you even think about selling, it's wise to get a free valuation of your current property to understand the potential tax implications down the line.

How to Choose the Right DST for Your Goals

Finding the right Delaware Statutory Trust is a lot like finding the right investment property—it requires careful research and a clear understanding of your goals. Not all DSTs are created equal, and the one you choose can make all the difference in whether you successfully transition your investment into a REIT. Think of this as your due diligence phase. You’re looking for a DST that not only qualifies for your 1031 exchange but also aligns with your long-term financial vision. This means digging into the details of the sponsor, the properties themselves, and the potential for a future REIT conversion. Taking the time to vet your options thoroughly will set you up for a much smoother and more predictable investment journey.

Vet the Sponsor and Understand the Fees

The DST sponsor is the company that acquires the properties, structures the trust, and manages the assets. Their experience and track record are incredibly important. Look into their history: How long have they been in business? What does their portfolio performance look like, especially during economic downturns? A reputable sponsor will be transparent about their strategy and results. It's also wise to assemble your own team of experts. A qualified intermediary, a financial advisor, and a tax professional can help you evaluate the sponsor and the fine print of the deal. They’ll also help you get a crystal-clear picture of the fees involved, which can include upfront costs, ongoing management fees, and disposition fees when the properties are sold.

Assess the Likelihood of a REIT Conversion

If your ultimate goal is to own REIT shares, you need to choose a DST with a clear path to get there. Some DSTs are specifically designed with a potential REIT conversion in mind. When this happens, you may be able to swap your interest in the DST for shares in the REIT’s operating partnership, known as OP Units, through a Section 721 exchange. This move allows you to continue deferring taxes. To find out if this is a possibility, you’ll need to review the DST’s offering documents, specifically the Private Placement Memorandum (PPM). Look for language that outlines a potential UPREIT (Umbrella Partnership Real Estate Investment Trust) transaction. Remember, this conversion is never a guarantee, so it’s important to understand the conditions and likelihood before you commit to an investment.

Analyze the Quality of the DST's Properties

At its core, a DST is a real estate investment. The value of your investment is tied directly to the quality of the properties within the trust’s portfolio. Before you invest, take a close look at the underlying assets. What kind of properties does the DST own—are they multifamily, retail, industrial, or something else? Where are they located? High-quality real estate holdings in strong markets with creditworthy tenants are more likely to generate consistent income and appreciate over time. A strong portfolio not only provides stable returns during the DST phase but also makes the trust a more attractive candidate for a future REIT conversion. Make sure the properties align with your personal risk tolerance and investment objectives.

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Frequently Asked Questions

Why can't I just use a 1031 exchange to buy REIT shares directly? This is the most common question, and the answer comes down to how the IRS classifies assets. A 1031 exchange is specifically for swapping "like-kind" real property, like trading one building for another. REIT shares, however, are considered securities, which the IRS classifies as personal property, similar to stocks. Because they aren't seen as the same type of asset, you can't make a direct, tax-deferred swap, which is why the Delaware Statutory Trust (DST) is used as a qualifying bridge.

What happens if the DST I choose never converts into a REIT? This is a real possibility and a key risk to consider. If a conversion doesn't happen, the DST will simply follow its original business plan. This typically means holding the properties for a set number of years, managing them to generate income, and then eventually selling them. When the properties are sold, you would receive your share of the proceeds, but this would become a taxable event, and all of your deferred capital gains would come due at that time.

Once I'm in a REIT, can I use a 1031 exchange to buy another property later? No, this move is a one-way street. Once you convert your DST interest into REIT shares through a 721 exchange, you have permanently moved your capital out of direct real estate ownership and into a security. Because REIT shares are not considered "like-kind" property, you lose the ability to perform another 1031 exchange with those funds. This is a major strategic trade-off you make in exchange for diversification and passive management.

How long should I expect this entire process to take? The process happens in two distinct phases with very different timelines. The first part, selling your property and using a 1031 exchange to invest in a DST, is on a strict deadline and must be completed within 180 days. The second part, the potential conversion from the DST into a REIT, has no set timeline. You should be prepared to hold your DST investment for several years before a conversion opportunity might arise, as it depends on the sponsor's strategy and market conditions.

What's the biggest tax mistake to avoid with this strategy? The most critical mistake is taking personal control of the funds from your property sale, even for a moment. You must use a Qualified Intermediary to hold the proceeds between the sale and the DST purchase to keep the exchange valid. Another major oversight is forgetting that the tax is only deferred, not eliminated. You need to plan for the substantial tax bill that will eventually come due when you sell your REIT shares, which will include capital gains and depreciation recapture.

By: Cameron Samimi

Author Bio: As one of the top producers in Los Angeles County for apartment buildings and recognized as one of the most respected real estate advisors, Cameron brings a wealth of information to the table to help his clients with real estate taxes, valuations, and maximizing returns. Cameron is our top agent here at Lyon Stahl and has led the fastest-growing real estate career we have ever seen at our company. The Los Angeles Business Journal recently recognized Cameron these past two years by nominating him for “Broker of the Year.” During his time at Lyon Stahl, he has received several awards including Top Producer (’18,’19,’20,’21,’22,’23) and High Velocity (’18,’19,’21,’22,’23) among others, and stands alone as our only agent to reach the Senior Vice President level with the company. It is hard to find a broker that is more trusted than Cameron. His ability to navigate new laws and market opportunities has helped him set market records for sales prices time and time again for his clients and bring them well above market returns. Cameron is an expert on 1031 Exchange Strategies, Real Estate Taxes, Apartment Flips, Underwriting and Valuations, and can help you or your clients maximize your real estate returns.