Sigma 1 receptor (S1R) is a 223-amino-acid-long transmembrane endoplasmic reticulum (ER) protein. S1R modulates activity of multiple effector proteins and is a well-established drug target. However, signaling functions of S1R in cells are poorly understood. Here, we test the hypothesis that biological activity of S1R in cells can be explained by its ability to interact with cholesterol and to form cholesterol-enriched microdomains in the ER membrane. By performing experiments in reduced reconstitution systems, we demonstrate direct effects of cholesterol on S1R clustering. We identify a novel cholesterol-binding motif in the transmembrane region of human S1R. Mutations of this motif impair association of recombinant S1R with cholesterol beads, affect S1R clustering in vitro and disrupt S1R subcellular localization. We demonstrate that S1R-induced membrane microdomains have increased local membrane thickness and that increased local cholesterol concentration and/or membrane thickness in these microdomains can modulate signaling of inositol-requiring enzyme 1α in the ER. Further, S1R agonists cause disruption of S1R clusters, suggesting that biological activity of S1R agonists is linked to remodeling of ER membrane microdomains. Our results provide novel insights into S1R-mediated signaling mechanisms in cells.