A Structured Exit From Directly Owned Real Estate

Owners of appreciated investment real estate eventually reach a familiar crossroads. For some, it is retirement. For others, a business sale, a partnership winding down, or plain management fatigue. Whatever the trigger, an outright sale converts decades of tax-deferred appreciation into an immediate tax bill, often a large one.

The bill adds up fast. Depreciation recapture takes a bite on its own. Add federal capital gains tax, the Net Investment Income Tax (NIIT), and state tax, and a third or more of the sale proceeds can disappear in the very year the property changes hands.

Swap Till You Drop

Many owners of appreciated real estate already know the classic answer to this problem. Internal Revenue Code (IRC) Section 1031, in place since the Revenue Act of 1921, allows an investor to defer tax on the sale of business or investment property by reinvesting the proceeds into a qualifying replacement property. Sell, roll the proceeds into another property, and the gain is simply not recognized yet.

Held long enough, the strategy goes further than deferral. Nothing stops an investor from exchanging one property for another, and then that one for another, repeating the process for decades. If the last property in that chain is still held at the owner's death, heirs generally receive a stepped-up cost basis equal to its value at that time. The gain deferred across every prior exchange effectively disappears. Real estate investors have called this swap till you drop for decades, and it remains one of the most durable tax strategies available to a property owner.

This benefit deserves a precise description. The stepped-up basis eliminates the federal income tax on the appreciation, not any separate estate tax. The property's fair market value is still included in the taxable estate, and federal estate tax can apply above the exemption amount, $15 million per individual for 2026, alongside any state-level estate or inheritance tax, several of which apply at far lower thresholds.

For most owners below those levels, the practical result is the same either way, no income tax is ever paid on the deferred gain. For larger estates, the income tax deferral and the separate question of estate tax exposure need to be planned for individually.

Still the Landlord

The 1031 exchange has one persistent problem. Each new exchange still requires locating, underwriting, and managing another physical property. The tax bill may be deferred indefinitely, but the daily burdens of direct ownership carry forward untouched, tenants, repairs, financing, concentration in a single asset and a single market. An investor who wants to stop being a landlord has traditionally had only one option, sell outright and pay the tax.

That gap is what the rest of this article addresses. Over the past two decades, the real estate industry has developed a series of structures that let an investor keep the deferral, and the eventual step-up in basis, while giving up the leases and the maintenance calls. None of the underlying tax law is new. IRC Section 1031 is over a century old, and the partnership provisions behind the later structures below are decades old themselves.

What has changed is how sponsors, the firms that organize, manage, and market these structures to individual investors, have packaged them, largely in response to what worked and what failed along the way.

One constraint has shaped every structure that follows. Multiple investors cannot simply pool money into a partnership or an LLC to buy a replacement property together and expect the exchange to hold up. Section 1031 explicitly excludes partnership interests from qualifying as like-kind property, so a pooled, passive structure has to be engineered around that exclusion rather than through it. Each fix described below solves this differently, one by putting every investor directly on the property's deed as an individual owner, the other through a trust structure with strict operating limits designed specifically to avoid being reclassified as a partnership.

Tenancy in Common

The earliest attempt at a passive version of the swap arrived well before the 2008 financial crisis. In a Tenancy in Common (TIC) interest, multiple investors each hold a direct, deeded interest in the same property, not a beneficial interest in a trust. IRS guidance issued in 2002, Revenue Procedure 2002-22, laid out the conditions under which a TIC interest could qualify as replacement property in a 1031 exchange, and TIC syndications quickly became the dominant passive vehicle.

A single TIC arrangement is tied to one specific property; an investor seeking exposure to several buildings needs a separate TIC interest in each. Ownership percentages can be unequal, generally reflecting how much each co-owner contributed, but financing is typically a single joint mortgage covering the whole property, with every co-owner jointly and severally liable for the full debt regardless of their individual ownership share.

TIC ownership also does not, by itself, shield an investor's other assets from claims against the property. Because each co-owner holds title directly, personal liability exposure is the default. Investors commonly address this by holding their TIC interest through a single-member LLC, a disregarded entity that preserves the direct-ownership treatment 1031 requires while still providing liability protection, a structuring decision that has to be made deliberately rather than assumed to happen automatically.

Governance is where TIC structures most often broke down. Refinancing, a lease renewal, a sale, almost any property-level decision generally required every co-owner to sign off. A handful of holdouts could freeze the property in place indefinitely.

Many TIC sponsors from the mid-2000s made it worse. They marked up properties heavily before syndicating them, then layered on debt the real estate could not support. A number of these deals failed outright once the 2008 downturn hit. That collapse pushed the market toward a different structure, one where a single trustee, not a roomful of co-owners, controls every decision.

The Delaware Statutory Trust

IRS Revenue Ruling 2004-86 confirmed that a fractional interest in a properly formed Delaware Statutory Trust (DST) can stand in as 1031 replacement property. A DST is a Delaware-law trust vehicle in which a sponsor pools investor capital to acquire and hold commercial real estate, sometimes a single building, often a portfolio of several, and each investor in turn receives a proportional beneficial interest rather than a deed of their own. A single trustee runs it, which is precisely the governance fix TIC could not solve on its own.

The trust structure also solves the liability question that a bare TIC interest leaves open. Because an investor holds a beneficial interest in the trust rather than direct title to the property, personal liability protection is built into the structure itself, without needing the single-member LLC workaround a TIC arrangement requires.

The replacement interest generally carries over the adjusted basis from the relinquished property rather than starting fresh at the new purchase price. Depreciation deductions during the DST phase are typically smaller than what a fresh cash purchase of a similar property would generate, since the depreciable basis carried into the exchange is usually the original, already-reduced figure rather than the property's current market value.

Sale proceeds cannot pass through the investor's own hands without breaking the exchange. Instead, they are held by a Qualified Intermediary, an independent third party who functions as an escrow agent between the relinquished property and the replacement asset.

The boot rule described earlier applies here with the same force. Sponsors typically offer DST interests across a range of loan-to-value ratios so an exchanger can match the replacement debt level to what the original property carried.

While the DST interest is held, distributions typically flow from a lease the trust holds with an affiliate of the sponsor's operating partnership, an arrangement commonly referred to as a Master Lease, rather than directly from the property's own rent roll. Because the lease payment, not the raw building cash flow, is what funds the distribution, a vacant unit or an unplanned repair at the property level does not immediately show up in what the investor receives. Tax reporting during this phase is typically delivered on a 1099-substitute basis, materially simpler than the direct-ownership return the investor previously filed.

The Master Lease structure introduces a counterparty layer that deserves to be named directly. The master tenant is typically a newly formed, thinly capitalized affiliate of the sponsor, so its own financial condition, not just the property's occupancy, can determine whether distributions keep flowing.

If the master tenant or the sponsor behind it runs into serious financial trouble, some DSTs include a springing LLC provision. This is a pre-written escape hatch in the trust agreement, letting the trust convert into an ordinary LLC that is free of the passive restrictions covered next, so its manager can actually renegotiate debt or bring in new capital to protect the property from a loan default. That conversion can solve the immediate crisis, but it also ends the trust's passive status and can close off future 1031 eligibility for that interest.

What a DST Trustee Cannot Do

A DST keeps its favorable tax treatment only by staying passive, and the trustee operates under a fixed set of restrictions built into the trust from the outset.

• No new capital: Once the offering closes, the trust cannot accept new investor capital, and existing investors cannot add to their position.
• No new or renegotiated debt: The trustee cannot refinance the property or take out new financing.
• No lease changes: Leases cannot be modified or replaced except in a tenant bankruptcy.
• No reinvestment of sale proceeds: If the property sells, the cash is distributed to investors directly rather than rolled into another asset.
• Limited capital improvements: Spending is restricted to routine repairs and anything required by law.

These restrictions exist for a specific reason, not just to keep the structure passive for its own sake. If a trustee crosses any of these lines, the DST risks being reclassified as a business entity or partnership rather than a passive trust, and partnership interests do not qualify as like-kind property under Section 1031. A violation would retroactively jeopardize every investor's exchange, not only the party responsible for it, which is why sponsors treat these limits as absolute rather than as guidelines. The tradeoff is inflexibility. If the property runs into trouble, the trustee has no lever to pull beyond what was already built into the trust on day one.

The DST solved TIC's governance problem, but it left a different limitation standing. Whether a DST holds one building or a portfolio of several, that pool is fixed at the offering's formation. The trustee cannot add properties, remove them, or rebalance the mix later, and the structure carries no built-in path to liquidity beyond a full-cycle sale. The next structural fix addresses that directly, converting the DST interest into a diversified, continuously managed, and periodically redeemable real estate investment trust (REIT) holding.

The table below lines up all four paths now that each has been covered.

Converting Into a Diversified REIT

IRC Section 721 shields a contribution of property to a partnership from immediate taxation, so long as the contributor receives nothing back except a partnership interest. This is the general rule that makes it possible for the DST's real estate to move into the REIT's operating partnership without triggering the very gain the exchange has deferred all along. The same section does related work for a concentrated position in publicly traded stock, contributed into a diversified exchange fund partnership, a strategy covered in Managing Concentrated Wealth, Part 1.

Applied here, the mechanism is an Umbrella Partnership Real Estate Investment Trust (UPREIT), a structure in which a REIT holds its properties indirectly, through a subsidiary Operating Partnership (OP). That layered ownership is what opens the door to a second, tax-deferred exchange, and it is the newest layer in this story, packaged as a marketed program only in roughly the last decade.

The REIT on the other side of that conversion is typically a private, non-traded, perpetual-life fund priced periodically at net asset value, not a publicly listed REIT bought and sold on an exchange, which matters directly for how liquid the resulting OP units actually are.

Sponsors commonly require every investor in a given DST to hold for at least two years, sometimes longer, before a Fair Market Value (FMV) Option opens up for the sponsor's operating partnership. This waiting period is not a fixed rule written into the tax code, and the IRS has not published an official safe harbor timeline for it.

It reflects a practice sponsors and their counsel use to reduce the risk that the IRS treats the two exchanges as one prearranged transaction under the step transaction doctrine, which could unwind the deferral entirely. Conservative sponsors lean toward the longer end of that range for this reason.

The FMV Option itself is the discretionary right, not the obligation, to acquire the DST's underlying property in exchange for units of the operating partnership. If a sponsor exercises this option, the DST interest converts into OP units through a second 721 exchange, again without recognizing gain.

This second exchange carries its own debt-related risk, distinct from mortgage boot in the first exchange. Under IRC Section 752, if the debt an investor is relieved of in the contribution exceeds their basis in the property, the excess can be treated as a deemed cash distribution and trigger taxable gain, even though the exchange is otherwise structured to defer tax. Sponsors generally structure the contribution and the resulting liability allocation to manage this risk, a detail that should be confirmed directly with a tax advisor before any conversion is finalized.

An OP unit is designed to track its corresponding class of REIT common shares closely, both in distribution rate and in per-unit value. That tracking cuts both ways. Once converted, risk shifts from a single property to the diversified REIT's own valuation, so if the broader REIT's underlying real estate declines in value, the OP units decline with it. OP unit holders also generally carry more limited voting rights than REIT common shareholders, a modest but real reduction in control that comes with the conversion.

Once an investor holds OP units, no further 1031 exchanges are needed to maintain deferral, and tax reporting shifts from the 1099-substitute of the DST phase to a Schedule K-1. That shift traces back to the same Section 721(a) mechanism described above. It only grants deferral on a contribution to a partnership, not on a contribution directly into a corporation, so the UPREIT structure holds its real estate through an Operating Partnership rather than inside the REIT itself, and a partnership taxed under Subchapter K reports to its holders on a K-1, not a 1099.

Because a diversified REIT typically owns property across many states, that K-1 often reports income apportioned across several state jurisdictions, which can require non-resident state returns or composite withholding, an administrative step best planned for rather than discovered at tax time. This K-1 treatment continues only while OP units are held. If units are later redeemed for REIT common shares rather than cash, that redemption is itself the taxable event described below, and from that point forward the investor holds ordinary REIT stock and receives a standard Form 1099-DIV going forward.

Comparing the Three States of Ownership

The Redemption Boundary

Deferral is conditional on continued holding, and the two-stage structure carries a boundary that is easy to overlook. Once OP units are redeemed for cash or for common REIT shares, whether after a year, a decade, or at any later point, the redemption is a taxable event. The deferred gain, built up across the original property and the DST phase before it, comes due at that point.

Redemption is also not available strictly on demand once the holding period passes. Sponsors commonly prorate redemptions, filling a large request gradually against a small percentage of outstanding units each quarter, and retain the discretion to gate the program entirely and pause redemptions if conditions warrant. Tax deferral inside this structure is therefore a function of continued holding, not a permanent exemption; sizing the allocation, and any liquidity plan around it, should account for this from the outset.

A DST interest that a sponsor chooses not to convert simply continues as a DST interest, generating Master Lease income without becoming a diversified, periodically redeemable OP unit. DSTs are not indefinite holdings either. Most are structured with their own planned exit, often five to ten years, after which the sponsor sells the underlying property and distributes proceeds regardless of whether a 721 conversion ever happened.

If the FMV Option was not exercised, that sale is a taxable event unless another 1031 exchange is completed at that point. A DST that does not convert still requires a further decision down the road, not indefinite passive deferral.

Applying the Structure to an Estate Plan

Held to the end, this structure arrives at the same destination as the classic swap till you drop strategy described at the start of this article, just by a more diversified and eventually liquid route.

A single physical building resists clean division among multiple heirs; it cannot be split evenly, and a forced sale to divide proceeds can trigger a discount, a rushed closing, or disagreement among family members with different views on timing. Converting that same economic value into fractional OP units removes the divisibility problem directly, since a unit count splits cleanly in a way a physical structure cannot.

Held until death, the structure also carries the deferred gain forward rather than requiring it to be recognized during the owner's lifetime. Heirs generally receive a stepped-up cost basis in the inherited units, which can substantially reduce or eliminate the built-up depreciation recapture and capital gains exposure the original owner had deferred.

That step-up applies automatically to the heir's own basis in the OP units under IRC Section 1014, but it does not by itself change the operating partnership's basis in the properties it holds. Closing that gap requires the operating partnership to have a valid Section 754 election in effect, which allows a matching adjustment under Section 743(b) to the heir's specific share of the partnership's inside basis.

Without that election, the heir's outside basis is stepped up but the partnership's own books are not, which can mean a larger allocation of taxable gain than the step-up would suggest when the underlying properties are eventually sold. Whether a given operating partnership maintains a Section 754 election is a sponsor-level decision to confirm as part of the diligence discussed below, not something an individual heir can arrange after the fact.

Each heir may then decide independently, and on an individual timeline, whether and when to redeem their own portion, without one heir's redemption decision forcing a similar decision on the others.

Minimums, Fees, and Identification Mechanics

DST minimums vary by sponsor and offering, but individual DST investments commonly start in the range of $25,000 to $100,000, a range that allows an exchanger to split proceeds across several DSTs for diversification rather than concentrating in a single property. A DST interest is also not reserved for investors coming out of a 1031 exchange. An accredited investor can make a direct cash investment into a DST as well, though only the exchange route defers an existing capital gain.

Fees are layered into the offering rather than billed separately, typically an upfront acquisition or offering fee plus an ongoing asset management fee, both of which reduce the return an investor ultimately receives relative to owning the property outright.

The standard 1031 identification rules still apply inside this structure. An investor generally has 45 days from the sale to identify a limited number of potential replacement properties or DST interests, commonly framed as the three-property rule or the 200 percent rule depending on how many candidates are named, and the full exchange must then close within 180 days of the original sale. Because DST interests are often pre-packaged and ready to close, they are commonly used to meet these deadlines when a physical replacement property has not been located in time.

Risks and Limitations

The mechanics described above work as intended in most cases. They also carry real risks that deserve equal attention alongside the benefits.

• Passivity shifts diligence onto the sponsor: Owners of a directly held property generally know its condition, tenants, and local market well. A DST interest asks an investor to trust a sponsor's underwriting of a property that may not be personally inspected, chosen and priced by that same sponsor, inside a 45-day window that discourages slow diligence.
• Performance has varied by sector and by cycle: Through the interest rate increases of 2022 through 2024, rising rates pushed capitalization rates higher across commercial real estate broadly, which put real pressure on property values regardless of how well a given asset was managed. How much pressure, and whether it showed up as reduced values or missed distributions, varied considerably by sponsor, by geography, and by asset type, rather than following any single pattern.
• Liquidity stays limited even after the holding period: There is generally no established secondary market for DST or OP unit interests. An investor who needs to exit early, whether because a property is underperforming or because personal circumstances change, is often limited to a private sale at a discount to fair market value, if a buyer can be found at all.
• A distressed resale market has emerged: Funds and buyers who specialize in acquiring distressed DST and TIC interests, generally at a meaningful discount, are now an established part of the market. Their presence indicates that this kind of distress is a real and recurring feature of the asset class, not a hypothetical risk.
• State tax treatment can outlast the federal deferral: California is the most aggressive example. If the relinquished property is California real estate and the replacement DST interest is not, California requires an annual information return for as long as the gain stays deferred, and continues taxing that gain when it is eventually recognized, even after a move out of state. A handful of other states have adopted similar tracking requirements.
• Master tenant financial health is a distinct risk from the property itself: Distributions depend on a thinly capitalized sponsor affiliate meeting its lease obligations, not solely on the property's own occupancy. Serious trouble there can force a springing LLC conversion, which protects the property but ends the trust's passive status and can close off future 1031 eligibility for that interest.

None of this means the structure is a poor fit for the right household. It means the diligence on the sponsor and the underlying property deserves the same rigor an investor would apply to buying real estate directly, even though the structure is built to feel passive.

Sponsor Evaluation

Because the FMV Option is discretionary and the underlying holdings are illiquid for a meaningful stretch of the timeline, a DST or UPREIT allocation is not a fit for every investor, even among those who technically qualify. Participation in these programs is generally restricted to accredited investors, and the structure works best for an investor genuinely prepared to hold a passive, long-term real estate position rather than one seeking near-term liquidity from the transaction.

Accreditation deserves a second look at each stage of this multi-year strategy rather than being treated as a one-time gate cleared at the start. Individual sponsor programs can also layer their own suitability standards on top of the baseline SEC requirement, and those standards can differ between the initial DST offering and whatever REIT program eventually offers the FMV Option. Confirming eligibility again before the conversion step, rather than assuming it carries over automatically, avoids an unwelcome surprise years into the holding period.

Selecting a sponsor is itself a diligence exercise, not a formality. A track record across prior real estate cycles, the diversification of the eventual REIT portfolio, the fee structure layered into the offering, and, for sponsors that run a redemption program at the OP unit stage, a consistent record of honoring those requests fairly, all merit review before capital moves into a DST interest.

Execution and Coordination

This sequential exchange is not a single decision but a multi-year commitment with a discretionary hinge point in the middle, and each stage depends on a different professional executing their role correctly:

• The initial exchange: A Qualified Intermediary handles the escrow, the 45-day identification window, and the 180-day closing deadline. A licensed registered representative at a broker-dealer sources and executes the DST purchase itself, since a DST is a securities offering the intermediary cannot legally sell, while a tax advisor confirms the replacement debt level avoids triggering boot.
• The holding period: A wealth manager with full visibility into the household's broader finances tracks whether the DST allocation still fits the household's liquidity needs and overall plan as years pass, while a CPA handles the annual grantor trust letter and reports the pass-through income on Schedule E.
• The discretionary conversion, if it happens: A real estate tax attorney reviews the Section 752 liability allocation before any 721 contribution is finalized, since the debt-over-basis exposure sits outside the original exchange entirely.
• The eventual estate transition: An estate planning attorney coordinates how OP units are titled and divided so the stepped-up basis and heir-level flexibility described above actually materialize as intended.

None of these steps is optional, and skipping coordination between them is usually what turns a sound strategy into a partially taxable one. Families holding a highly appreciated, actively managed property should evaluate this structure alongside the full range of exit alternatives well before a sale becomes urgent, so that the identification and exchange windows do not have to be navigated under time pressure.

One caution belongs at the end rather than buried in the mechanics above. The tax deferral described throughout this article is real, but it is a reason to consider a replacement property or sponsor, not a reason to accept one that would not stand on its own merits as an investment. A property or REIT that is attractive only because it defers a tax bill is not a sound holding once that bill eventually comes due. The investment case should hold up on its own before the tax treatment gets counted as a benefit at all.