Beyond the 1031 Exchange: How upREITs Let You Defer Taxes and Diversify Out of Real Estate

A 1031 exchange defers the gain but keeps you a landlord. Run through a REIT's 1031-to-upREIT program, the same exchange can end in a diversified portfolio you can liquidate a piece at a time, on your schedule.

If you have owned investment real estate for twenty or thirty years, you have probably reached the point where the property has done everything you asked of it. It has appreciated. You have depreciated most of what can be depreciated. And the work of owning it, the tenants, the repairs, the insurance renewals, the refinancing decisions, has started to outweigh the satisfaction.

The obvious move is to sell. The obstacle is the tax bill, and for most long-held properties it is large enough to keep owners in place for years longer than they want to be. This article walks through the three ways out: selling outright, exchanging into another property, and a 1031 exchange that ends in the operating partnership of a real estate investment trust. We run the numbers on a $5 million apartment complex and set out what each path costs and what can go wrong.

What Selling Actually Costs

When you sell appreciated real estate, your gain is the sale price less your adjusted basis, and your adjusted basis has been shrinking every year you took depreciation. That gain is taxed in layers:

Unrecaptured Section 1250 gain. The portion of your gain equal to the depreciation you took on the building is taxed at your ordinary income rate, capped at 25%.
Long-term capital gain. The rest of the gain is taxed at 0%, 15%, or 20%. For 2026, the 20% rate applies to married couples with taxable income above $613,700 ($545,500 for single filers).
Net investment income tax. An additional 3.8% applies to the gain to the extent your modified adjusted gross income exceeds $250,000 for married couples ($200,000 for single filers). Those thresholds are fixed by statute and are not indexed for inflation.

On a property bought decades ago, most of the sale price can be gain. A large sale in a single year pushes nearly all of it into the top rates, and the 3.8% applies to almost every dollar.

The 1031 Exchange, Briefly

Section 1031 lets you defer that gain by exchanging investment or business real estate for other real estate held the same way. Since 2018, the exchange has been limited to real property; the One Big Beautiful Bill Act, signed July 4, 2025, left Section 1031 untouched. "Like-kind" is broad within real estate: an apartment complex can be exchanged for raw land, a warehouse, or a retail center. The rules that matter in practice are mechanical:

The 45-day identification window. You have 45 days from the sale of your property to identify replacement property in writing. You may identify up to three properties of any value, any number of properties whose combined value does not exceed 200% of what you sold, or more than that if you actually acquire at least 95% of the value identified.
The 180-day closing deadline. You must close on the replacement property within 180 days of the sale, or by the due date of your return for that year (with extensions) if earlier.
The qualified intermediary. You cannot touch the sale proceeds. A qualified intermediary holds them from the sale until the purchase. Receiving the money yourself, even briefly, can disqualify the exchange.
Boot. Cash you take out, and debt you are relieved of without replacing, is taxable. If your old property carried a $1 million mortgage, your replacement needs at least $1 million of new debt, or you need to add the difference in cash.

Done correctly, a 1031 exchange defers all of the gain. Your basis in the old property carries over to the new one, so the gain is postponed rather than forgiven.

The 1031 Treadmill

The limitation is built into the structure: to keep deferring, you have to keep owning real estate. Each exchange puts you back in the position of owning, managing, and eventually selling another property, under the same 45-day and 180-day clock. Owners who do this for decades end up on what practitioners call the 1031 treadmill.

The 45-day window is where most exchanges come under pressure. Finding, underwriting, and committing to a suitable replacement property in six weeks is hard in any market, and an exchange that misses the window is simply a taxable sale.

Owners on the treadmill usually want three things they cannot get from another building: diversification beyond one or two properties, freedom from management, and the ability to take money out without triggering the entire gain.

Why the Exchange Has to Land in a DST

A diversified, professionally managed real estate portfolio already exists in the form of a real estate investment trust. The problem is that REIT shares are stock, and interests in the REIT's operating partnership are partnership interests. Neither is real property, so your sale proceeds cannot be exchanged into either one under Section 1031.

Many REITs are organized as "umbrella partnership" REITs, or upREITs: they hold their properties through an operating partnership that issues operating partnership units (OP units). Several of them have built programs that let 1031 investors reach those units in two tax-deferred steps, with a Delaware statutory trust (DST) in between.

How the 1031-to-upREIT Program Works

The DST is not a separate destination in this program. It is the front door the REIT builds so that the proceeds of your sale can be exchanged into real estate under Section 1031 and end up in its operating partnership. You never contribute your own building to the REIT; you sell it, and your qualified intermediary uses the proceeds to buy into the REIT's DST. The program runs in three steps.

Step 1: The REIT's operating partnership buys property and places it in a DST. The operating partnership acquires institutional-quality real estate, puts title in a DST it sponsors, and, through a subsidiary, master-leases the property back from the trust and guarantees the lease payments. Many of these DSTs hold several properties, often across different markets and tenants, so even before the conversion your exchange buys you a diversified position rather than another single building.

Step 2: You exchange into the DST. You sell your property through a qualified intermediary and buy beneficial interests in the DST as your replacement property. Under Revenue Ruling 2004-86, an interest in a properly structured DST is treated as a direct interest in the underlying real estate, so it qualifies for the 1031 exchange, and your gain stays deferred. Because the interests are already packaged and available in whatever dollar amount you need, identifying replacement property inside the 45-day window is no longer a scramble. When you subscribe, you grant the operating partnership a fair market value option to acquire the trust's property, generally exercisable beginning about two years after the offering.

Step 3: The operating partnership exercises its option and you receive OP units. Your DST interests are exchanged for OP units equal to their then fair market value. That exchange is governed by Section 721, which allows property to move into a partnership in exchange for partnership interests without recognizing gain, so the gain deferred in your 1031 exchange stays deferred. You have gone from one building you managed, to an interest in a group of properties managed by the REIT, to a stake in the REIT's entire diversified portfolio.

The DST is used as the entry point because a DST interest counts as real estate for 1031 purposes and an OP unit does not. To keep that treatment, the trust has to stay passive while you hold it: the ruling prohibits the trustee from taking on new equity, refinancing or adding debt, reinvesting sale proceeds, making more than limited capital improvements, renegotiating existing leases or signing new ones (outside narrow exceptions), or holding cash other than in short-term instruments. The master lease to the operating partnership's subsidiary is what makes those limits workable during the holding period.

Two points about the option deserve attention before you subscribe:

It is the operating partnership's option. The program is designed around the conversion, and sponsors generally exercise. The offering documents we have reviewed, however, give the operating partnership the right, but not the obligation, to do so. If it does not, you remain in the DST, and you keep the ability to do another 1031 exchange when the DST property is eventually sold.
The operating partnership may be able to pay cash instead of units. Some offerings let the operating partnership satisfy the option with cash at its discretion. Only units are tax-deferred under Section 721. Cash is a taxable sale. Read the terms and ask the sponsor how it has exercised in prior programs.

OP units are designed to track the economics of the REIT's shares, with distributions in place of dividends. Holders receive a Schedule K-1 rather than a Form 1099 and may have filing obligations in states where the partnership owns property. After a holding period, commonly one year, units can be exchanged for REIT shares or cash, at the operating partnership's election.

The Real Advantage: You Decide When the Gain Shows Up

This is the part of the strategy that tends to get lost in the marketing. A building is all or nothing. When you sell it, you sell all of it, and the entire gain is recognized in one year. You can sell a fractional interest in theory, but almost no buyer wants one.

The traditional way around that was the installment sale: sell the property, take back a seller's note, and recognize the gain as the payments come in. It still works under Section 453, but few sellers use it today. You have sold the property but not exited the risk; you have become your buyer's lender, with your retirement tied to one borrower's ability to pay. The unrecaptured Section 1250 gain is also reported first, before the lower-rate gain, as payments arrive.

OP units work differently. You can exchange a portion of your units for REIT shares or cash this year, more next year, and none the year after. Each exchange is generally taxed as a sale of those units, and the character of the gain carries through, so the depreciation-related portion is still taxed at up to 25% and the rest as long-term capital gain. What changes is that you control how much gain lands in each year, and the remaining units keep earning distributions while you wait.

There is a practical limit on the pace. REIT share repurchase programs typically cap redemptions; one large sponsor's current materials limit them to 5% of shares per quarter, or 20% per year, and repurchases can be suspended. A plan to liquidate over several years fits comfortably within those limits. A plan to liquidate everything at once does not.

And the units you never sell can pass to your heirs. OP units held at death generally receive a stepped-up basis under Section 1014, so the deferred gain on those units is never subject to income tax. Under current law, the federal estate tax exemption is $15 million per individual and $30 million per married couple, made permanent by the One Big Beautiful Bill Act, so for most owners the step-up comes with no estate tax at all.

Worked Example: The $5 Million Apartment Complex

Consider a married couple, both retired, who have owned an apartment complex for decades. The assumptions:

Current value of $5,000,000, with no mortgage.
Adjusted basis of $500,000, after $1,000,000 of depreciation. Total gain is $4,500,000: $1,000,000 of unrecaptured Section 1250 gain and $3,500,000 of long-term capital gain.
$100,000 a year of other ordinary income (pensions and retirement plan withdrawals), standard deduction, filing jointly, living in a state with no income tax.
2026 federal brackets and thresholds applied in every year, and the value of the property and units held constant, so the comparison isolates the effect of timing. Rental income, OP distributions, sponsor fees, and selling costs are excluded from all paths.

Path 1: Sell Outright

The full $4,500,000 gain is recognized in 2026. The unrecaptured Section 1250 gain is taxed at the couple's ordinary rates up to the 25% cap. The capital gain sits entirely in the 20% bracket. The 3.8% net investment income tax applies to all but $150,000 of the gain. Total additional federal tax: $1,105,770 . The couple walks away with $3,894,230 to reinvest.

Path 2: Exchange Into Another Building

A 1031 exchange into a $5,000,000 replacement property defers the entire gain. Nothing is owed in 2026, and the full $5,000,000 stays invested. But the couple is still a landlord, now of a property they have owned for six months, and when they eventually sell, they face the same all-or-nothing problem as Path 1.

Path 3: The 1031-to-upREIT Program

The couple exchanges into a DST in a REIT's 1031-to-upREIT program. Nothing is owed in 2026. The operating partnership exercises its option, and the couple's interest becomes OP units worth $5,000,000. They then exchange 10% of their units each year for ten years.

Each year they recognize $450,000 of gain: $100,000 of unrecaptured Section 1250 gain and $350,000 of capital gain. At that level, the Section 1250 portion is taxed at 12% and 22%, the capital gain stays entirely in the 15% bracket, and the net investment income tax reaches only the $300,000 of income above the $250,000 threshold. The additional federal tax is $82,600 a year , or $826,000 over ten years.

That is $279,770 less tax than selling outright, a reduction of about 25%, before counting the value of deferring most of the tax for years and keeping the untaxed capital invested and earning distributions in the meantime.

A variation shows the full range. If the couple exchanges only 5% of their units a year for ten years, taking half the position, the additional tax is $36,800 a year, or $368,000 in total. The other $2,500,000 of units passes to their children with a stepped-up basis, and the $2,250,000 of gain built into those units is never taxed.

The savings come from three places: the capital gain is taxed at 15% instead of 20%, the Section 1250 gain falls in brackets below 25%, and the $250,000 net investment income tax threshold is used once a year rather than once in total. The higher the couple's other income, the smaller the bracket benefit; the deferral and the step-up remain either way.

Compare selling, a 1031 exchange, and the upREIT path with your property's numbers in our Real Estate Exit Strategy Comparison.

What It Costs and What Can Go Wrong

The 1031-to-upREIT program is not free, and it is not right for everyone. Before committing, an owner should understand:

Fees. DST offerings carry upfront charges. One large sponsor's current materials list a sales charge of up to 2%, a 1% placement fee, and third-party costs of up to 1.25% for debt-free offerings, plus annual servicing and management fees, and a 1% fee when the operating partnership exercises its option. Those costs come out of the equity you exchange.
A one-way door. Once you hold OP units, you cannot do another 1031 exchange with that capital. Any sale of units is taxable.
Loss of control. You no longer decide when properties are bought, sold, refinanced, or improved. The operating partnership does.
Conversion terms. The operating partnership decides whether and when to exercise its option, and, in some programs, whether to pay in units or cash.
Liquidity limits. There is generally no public market for DST interests or OP units. Exchanges into REIT shares and share repurchases are subject to program limits that can be changed or suspended.
Debt replacement. If your property has a mortgage, the DST interest you buy must carry at least as much allocated debt, or you must add cash, to avoid taxable boot.
DST failure modes. If a DST runs into trouble that its trustee cannot address within the Revenue Ruling 2004-86 limits, the trust may convert into a limited liability company, which is not treated as a direct interest in real estate and can end your 1031 protection.
Paperwork. K-1s instead of 1099s, often arriving later, and possible filings in multiple states.

Which Path Fits

Sell outright when you need the full proceeds now, your gain is modest, or you have losses to absorb it.
Exchange into another building when you want to keep owning and managing real estate and have a specific property in mind.
Use the 1031-to-upREIT program when you want out of management for good, want diversification, and want to decide year by year how much gain to recognize, with the option of leaving the rest to your heirs.

The Bottom Line

The 1031 exchange is the right starting point for almost every owner leaving appreciated property. What matters is where it leads. Exchanging into another building keeps the deferral going but keeps you a landlord, with the same all-or-nothing sale waiting at the end. Exchanging through a REIT's 1031-to-upREIT program trades control and some cost for diversification, freedom from management, and something a building can never offer: the ability to liquidate a piece at a time, recognizing gain in the years you choose, and leaving the rest to pass with a stepped-up basis.

The details of each program matter, from the terms of the option to the fees and the redemption limits. So does the order of operations, because the decision has to be made before the 45-day clock starts.

See how selling, a 1031 exchange, and the upREIT path compare for your property. Try our Real Estate Exit Strategy Comparison.

Book a consultation to talk through your exit before you list the property.

Disclaimer: This article is for informational purposes only and does not constitute legal or tax advice. The worked example uses illustrative assumptions, holds property values constant, and excludes rental income, distributions, fees, and state taxes; sponsor terms and fees described are drawn from one sponsor's current offering materials and vary by program. The application of Sections 1, 453, 721, 1014, 1031, 1250, and 1411 of the Internal Revenue Code, Revenue Ruling 2004-86, and related provisions depends on individual facts and circumstances. Consult a qualified tax attorney or CPA before making decisions based on this information. Circular 230 Notice: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of avoiding penalties under the Internal Revenue Code.

R Jason Griffin | Oct 19 2026 03:10