721 Exchange via DST: Complete Guide to Pros and Cons
Learn how 721 exchanges through Delaware Statutory Trusts can provide tax deferral, diversification, and liquidity for real estate investors.
Key Takeaway
A 721 exchange via DST allows investors to transition from direct property ownership to diversified REIT investments while continuing to defer capital gains taxes from their original 1031 exchange. This strategy provides professional management, diversification, and potential liquidity, but requires giving up direct control over investment decisions.
What is a 721 Exchange (UpREIT)?
A 721 exchange is a tax-deferred investment strategy that follows a 1031 exchange into a Delaware Statutory Trust (DST). It allows real estate investors a way to defer taxes today and diversify into a large, professionally managed real estate portfolio in the future.
How a 721 Exchange Works:
- Initial 1031 Exchange: You sell your investment property and use a 1031 exchange to reinvest the proceeds into a DST
- DST Ownership: The DST owns institutional-grade properties such as multifamily apartments, industrial facilities, or medical offices
- 721 Exchange: Later, the DST can "roll up" into a Real Estate Investment Trust (REIT) through a 721 exchange
- OP Units: Your DST ownership converts to Operating Partnership (OP) units of the REIT
- Continued Deferral: You stay invested without triggering capital gains taxes at the time of conversion
This pathway offers a way to transition from actively managing properties to enjoying fully passive ownership, all while continuing to defer taxes. For many investors, this strategy provides access to liquidity, diversification, and larger-scale real estate opportunities.
Considering a 721 exchange strategy? Our experienced team can help you evaluate whether this approach aligns with your investment goals and timeline.
Schedule a CallBenefits of a 721 Exchange via DST
Continued Tax Deferral
A 721 exchange preserves the tax advantages of your original 1031 exchange. By deferring capital gains and depreciation recapture, you keep more of your capital working for you, compounding over time rather than being eroded by taxes today.
Professional Diversification
When you exchange into a REIT, you gain exposure to a professionally managed portfolio that often spans multiple geographic markets and asset classes including multifamily, industrial, net-lease, self-storage, and data centers.
Passive Management
The day-to-day management burden disappears. Instead of dealing with tenants, maintenance, leasing, and refinancing headaches, you receive distributions from the REIT while your investment is managed by professional asset managers.
Liquidity Options
After a required holding period, OP units can often be converted into REIT shares at the discretion of the investor. While the conversion is a taxable event, it potentially allows you to convert to cash when liquidity is needed.
Estate Planning Benefits:
One of the biggest benefits of OP units or REIT shares is that they are easier to divide among heirs compared to fractional DST interests or physical properties. They also receive a step-up in cost basis upon inheritance, often reducing or eliminating capital gains taxes for the next generation.
Potential Risks to Consider
Important: A DST with a 721 exit is not the right fit for every investor.
Loss of Control
The primary benefit of going passive is also a double-edged sword. Once you convert to OP units, you no longer have direct ownership of the underlying property.
- Key decisions like asset sales or refinancing are made by the REIT's management team
- Important to conduct due diligence on the asset manager, not just the DST
- No direct influence over property-level decisions
Holding Period Requirements
OP units usually come with a holding period, sometimes years, during which you can't convert them into more liquid REIT shares. This locks up your investment and reduces flexibility.
Market Risk Exposure
While private REITs offer diversification, they are still subject to market cycles, interest rate changes, and property performance. Understanding critical real estate investment risks is essential.
- Large, diversified REITs often reflect the whole real estate market
- When property values decline, REIT NAV often follows
- Interest rate changes can affect both property values and distributions
Future Tax Obligations
A 721 exchange defers capital gains and depreciation recapture, but those taxes will eventually come due when OP units are converted to shares and sold, or if the REIT sells assets and passes through gains.
Understanding "721 Optional" vs. "721 Required" DSTs
When evaluating DST investments, you'll often see properties labeled as "721 Optional," "721 Required," or "No 721 Option." Understanding these designations is crucial for your investment decision.
721 Optional
Most flexible option. You can choose to participate in a 721 exchange if the opportunity arises, but you're not required to. If the 721 opportunity doesn't arise or you choose not to participate, you can always do a standard 1031 exchange into any qualifying property. This gives you maximum control over your exit strategy.
721 Required
Mandatory conversion. All investors must participate in the 721 exchange when it occurs. You cannot opt out, which means you'll receive REIT OP units whether you want them or not.
No 721 Option
Traditional DST exit. The property will be sold at the end of the hold period with proceeds distributed to investors. No REIT conversion opportunity, but investors can use the proceeds for another 1031 exchange into DSTs, direct property ownership, or other qualifying investments.
Why "721 Optional" is Often Preferred:
- • Flexibility: You decide whether to convert or receive cash from property sale
- • No forced decisions: You're not locked into REIT ownership if your circumstances change
- • Market timing: You can evaluate REIT performance and market conditions before deciding
- • Tax planning: Choose the exit strategy that best fits your tax situation at the time
Is a 721 Exchange Right for You?
Good Fit If You Want To:
- Transition from active property management to passive investment structure
- Maintain tax deferral while accessing greater diversification
- Create liquidity options for future needs
- Simplify estate planning and generational wealth transfers
Consider Alternatives If You:
- Prefer to maintain direct control over investment decisions
- Need immediate liquidity or short investment horizons
- Are uncomfortable with market volatility affecting your investment
- Want to avoid potential future tax obligations
Need help evaluating if a 721 exchange fits your portfolio? Our team specializes in helping investors transition from active to passive real estate investing.
Schedule a ConsultationFrequently Asked Questions
What is a 721 exchange?
A 721 exchange is a tax-deferred investment strategy that follows a 1031 exchange into a Delaware Statutory Trust (DST). It allows real estate investors to defer taxes today and diversify into a large, professionally managed real estate portfolio in the future by converting DST ownership into REIT Operating Partnership (OP) units.
How long do I have to hold OP units before converting to REIT shares?
Holding periods vary by REIT but typically range from 1-3 years. During this period, you cannot convert OP units to tradeable REIT shares. The specific holding period is outlined in the Operating Partnership Agreement and should be reviewed carefully before investing.
What taxes will I owe when I eventually sell?
When you convert OP units to REIT shares and sell, you'll owe capital gains taxes on the original deferred gain from your 1031 exchange, plus any additional appreciation. The tax rate depends on your holding period and tax bracket at the time of sale.
Can I do a 721 exchange with any DST?
No, only DSTs sponsored by companies that also operate REITs can offer a 721 exchange option. The DST must be structured specifically to allow for future conversion to REIT OP units. Not all DST investments have this exit strategy available.
In Summary
- • 721 exchanges via DST provide a pathway from active to passive real estate investing
- • Benefits include continued tax deferral, diversification, professional management, and estate planning advantages
- • Key risks include loss of control, holding periods, market exposure, and future tax obligations
- • Best suited for investors prioritizing passive income and diversification over direct control
- • Requires careful due diligence on both the DST sponsor and REIT management team
About the Author
Thomas Wall, Partner
Thomas Wall has a decade of experience in real estate and capital markets. He has helped financial advisors at banks and wirehouses navigate a broad spectrum of equity, debt, and retirement investments at AIG which contributed to over $200MM of capital invested. Thomas specialized in helping real estate investors navigate the transition from active management to passive real estate investing, advising high-net-worth investors on 1031 exchanges, DSTs, private real estate offerings, and REITs. He has helped investors through hundreds of 1031 exchanges, placing over $230MM of equity into real estate.
Important Disclaimer:
Because each investor's situation is unique, it's essential to review your financial goals, tax position, and estate planning needs with your qualified tax advisor, financial advisor, and attorney before moving forward with any investment strategy.
Disclosure
Tax Complexity and Investment Risk
Tax laws and regulations, including but not limited to Internal Revenue Code Section 1031, bonus depreciation rules, cost segregation studies, and other tax strategies, contain complex concepts that may vary depending on individual circumstances. Tax consequences related to real estate investments, depreciation benefits, and other tax strategies discussed herein may vary significantly based on each investor's specific situation and current tax legislation. Anchor1031, LLC and Great Point Capital, LLC make no representation or warranty of any kind with respect to the tax consequences of your investment or that the IRS will not challenge any such treatment. You should consult with and rely on your own tax advisor about all tax aspects with respect to your particular circumstances. Please note that Anchor1031 and Great Point Capital, LLC do not provide tax advice.
The information contained in this article is for general educational purposes only and does not constitute legal, tax, investment, or financial advice. This content is not a recommendation or offer to buy or sell securities. The content is provided as general information and should not be relied upon as a substitute for professional consultation with qualified legal, tax, or financial advisors.
Tax laws, regulations, and IRS guidance regarding 1031 exchanges are complex and subject to change. Information herein may include forward-looking statements, hypothetical information, calculations, or financial estimates that are inherently uncertain. Past performance is never indicative of future performance. The information presented may not reflect the most current legal developments, regulatory changes, or interpretations. Individual circumstances vary significantly, and strategies that may be appropriate for one investor may not be suitable for another.
All real estate investments, including 1031 exchanges, are speculative and involve substantial risk. There can be no assurance that any investor will not suffer significant losses, and a loss of part or all of the principal value may occur. Before making any investment decisions or implementing any 1031 exchange strategies, readers should consult with their own qualified legal, tax, and financial professionals who can provide advice tailored to their specific circumstances. Prospective investors should not proceed unless they can readily bear the consequences of potential losses.
While the author is a partner at Anchor1031, the views expressed are educational in nature and do not guarantee any particular outcome or create any obligations on behalf of the firm or author. Neither Anchor1031 nor the author assumes any liability for actions taken based on the information provided herein.