Transposable elements profoundly affect the biology and evolution of their hosts, yet their own evolutionary dynamics remain poorly understood. Here, we investigate insect endogenous retroviruses (iERVs), a monophyletic group of LTR retrotransposons that have acquired the trait of infectivity, likely through capture of a Baculovirus envelope gene. In Drosophila ovaries, iERVs with functional envelope have adapted their expression to any somatic cell type, from where they infect the germline. Strikingly, related retroviruses show distinct expression patterns, indicating niche partitioning. In contrast, all non-infectious iERVs that emerged through secondary envelope-loss are specifically expressed in the germline. Using transgenic reporters in vivo and sequence analysis of multiple iERV lineages including the variants of the transition element rover, we elucidate how this discrete co-variation evolved via changes in i) the elements transcriptional cis-regulatory sequences and ii) their functional envelope status (intact/defective). Notably, the genome-protecting piRNA pathway - co-evolving with iERVs - has assimilated iERV promoter and sequence information into piRNA clusters, underscoring the functional significance of iERV expression in somatic niches. We propose that the evolutionary innovation of cell-to-cell infectivity gave rise to the iERV ancestor which then diversified through trait diversification and antagonistic virus-host interactions, processes that likely underpin niche-specific expression of endogenous retroviruses in vertebrates as well.