Key Takeaways
- The IRS classifies REIT shares as securities, not real property, so they do not may have access to as replacement property in a 1031 exchange.
- A 1031 exchange requires you to buy real property you control directly, such as a rental house, apartment building, or land.
- Selling investment real estate to buy REIT shares triggers capital gains tax in the year of the sale, with no deferral option.
- You can use a 1031 exchange to move from one direct real estate investment to another, including into a property that a REIT might own.
- REIT dividends are taxed as ordinary income each year, whereas a 1031 exchange defers taxes until you eventually sell the replacement property.
Why the IRS Treats REIT Shares Differently
The 1031 exchange rule exists because Congress wanted to encourage real estate investment by letting owners reinvest without an immediate tax hit. The law says you must exchange real property for real property — meaning you have to own and control the actual asset. When you buy REIT shares, you own a fractional stake in a fund that owns property, but you do not own the property itself or control how it is managed.
The IRS has been clear on this point for decades. Even if a REIT owns only apartment buildings or office parks, the shares remain securities in the eyes of tax law. The same rule applies to other real estate investment vehicles: you cannot use a 1031 exchange to buy into a real estate mutual fund, a real estate crowdfunding platform, or a partnership that owns property on your behalf.
This distinction matters for your tax bill. When you sell investment real estate, you owe capital gains tax on your profit — the difference between your sale price and your original cost basis, plus improvements. That tax is due in the year you sell. A 1031 exchange lets you skip that payment by rolling the proceeds into new property. Without the exchange, you pay the tax immediately.
What Counts as Real Property in a 1031 Exchange
The IRS has a specific list of what qualifies as replacement property in a 1031 exchange. You can exchange into a rental house, an apartment building, a commercial office or retail space, raw land, a farm, a parking lot, or a storage facility. You can also exchange into a property you will lease to a business, as long as you retain ownership and the lease is structured correctly.
The property does not have to be the same type as what you sold. You can sell a rental house and buy an office building. You can sell a commercial property and buy raw land. The only hard rule is that the replacement property must be held for investment or business use — you cannot buy your primary residence or a vacation home you plan to use personally.
Some investors use 1031 exchanges to move into properties that REITs also invest in — for example, selling a single rental house and buying into a small apartment complex or a strip mall. That works because you own the property directly. The tax deferral applies to your gain, and you keep control of the asset.
The Timeline and Mechanics of a 1031 Exchange
A 1031 exchange has strict timing rules that make it different from a regular sale. You have 45 days from the closing date of your sale to identify the replacement property in writing. You then have 180 days total to close on that property. If you miss either deadline, the entire exchange fails and you owe capital gains tax on your original sale.
You must use a may have access to intermediary — a third party who holds the sale proceeds and transfers them to the seller of the replacement property. You cannot touch the money yourself, or the IRS will treat the exchange as a taxable sale. The intermediary is not your real estate agent or your accountant; it is a specialized firm that handles only 1031 exchanges.
Because of these rules, a 1031 exchange takes planning. You need to know roughly what type of property you want before you list your current one for sale. You need to have a may have access to intermediary lined up before closing. And you need to move fast once you have a buyer, because the 45-day clock starts immediately.
Tax Consequences of Selling Into a REIT Instead
If you sell investment real estate and buy REIT shares instead of using a 1031 exchange, you will owe capital gains tax on your profit in the year of the sale. The rate depends on how long you held the property. If you owned it for more than one year, you pay long-term capital gains tax, which is lower than ordinary income tax rates. If you owned it for one year or less, you pay short-term rates, which are taxed as ordinary income.
Long-term capital gains rates are 0%, 15%, or 20% depending on your total income for the year. For most homeowners and small investors, the rate is 15%. On a $100,000 profit, that would be $15,000 in federal tax, plus any state income tax your state charges. You also may owe a 3.8% net investment income tax if your modified adjusted gross income exceeds certain thresholds.
After you buy REIT shares, you will owe tax again each year on the dividends the REIT pays out. Those dividends are taxed as ordinary income, not capital gains, so the rate is higher. Over time, this annual tax bill can add up significantly compared to a 1031 exchange, where you defer all taxes until you eventually sell the replacement property.
When a Direct Real Estate Purchase Makes Sense Instead
Some investors use a 1031 exchange to move from one direct property into another, then eventually into a REIT when they want to step back from active management. This approach lets you defer taxes on the first sale and reinvest into a property you control, then later sell that property and pay capital gains tax to move into a REIT.
This strategy works if you want to reduce your workload over time. Direct real estate ownership requires you to handle maintenance, tenant issues, property taxes, and insurance. A REIT lets you own real estate exposure without those responsibilities. The trade-off is that you lose control and you pay tax on the transition.
Another option is to hold the direct property until you pass it to your heirs. When you die, your heirs receive a "stepped-up basis," meaning the property's value resets to its fair market value on the date of your death. They can then sell it with little or no capital gains tax. This approach avoids the 1031 exchange entirely but requires you to hold the property for life.
Alternatives to a 1031 Exchange for REIT Investors
If you want to move money from direct real estate into a REIT while minimizing taxes, you have a few options. One is to sell the property, pay the capital gains tax, and then buy REIT shares with the after-tax proceeds. This is straightforward but expensive in the year of the sale.
Another option is to use a 1031 exchange into a Delaware Statutory Trust (DST). A DST is a legal structure that holds real property on behalf of investors. You can exchange the proceeds from your sale into a DST, which then owns an actual building or portfolio of buildings. This defers your capital gains tax and keeps you in direct real estate ownership, though you have less control than owning the property outright. After holding the DST for a period, you could later sell it and use another 1031 exchange to move into a different asset.
A third option is to donate the property to a charitable remainder trust if you want to support a cause. This can reduce your taxable gain and provide you with income for life, though it requires the property to go to charity eventually. This is complex and requires working with an attorney and tax professional.
Frequently Asked Questions
Can I use a 1031 exchange to buy into a real estate crowdfunding platform?
No. Crowdfunding platforms, like REITs, issue securities rather than direct ownership of property. The IRS does not treat them as real property for 1031 purposes. You would owe capital gains tax on the sale of your original property.
What if I use a 1031 exchange to buy a property, then later sell it to buy REIT shares?
That works, but you will owe capital gains tax on the second sale. The 1031 exchange defers taxes on the first sale only. When you sell the replacement property, you pay tax on whatever gain you made since you bought it, unless you use another 1031 exchange at that point.
Do REIT dividends count toward the 1031 exchange rules?
No. REIT dividends are separate from the 1031 exchange. If you receive dividends from a REIT you already own, they are taxed as ordinary income each year. The 1031 rules apply only to the sale and reinvestment of real property itself.
Can I exchange into a property and then immediately sell it to a REIT?
Technically yes, but the IRS may challenge it. If you buy a property through a 1031 exchange and sell it within a short time to a REIT or other buyer, the IRS might argue you never intended to hold it for investment and disallow the exchange. There is no set holding period, but most tax professionals recommend holding for at least one to two years to be safe.