DST to REIT Conversion: The Ultimate 721 Exchange Guide
Real estate investors often find themselves in a challenging position when their Delaware Statutory Trust (DST) investments reach maturity. After years of passive income and tax deferral, the question becomes: what next? Traditional exit strategies can trigger significant tax liabilities, but there's a sophisticated solution that many investors overlook: the 721 exchange into a Real Estate Investment Trust (REIT).
Having worked with hundreds of investors navigating these transitions, I've seen how the right strategy can transform a potential tax burden into an opportunity for enhanced liquidity and continued tax deferral. Let me walk you through exactly how this works and why it might be the solution you've been looking for.
Understanding the DST Dilemma
When you invest in a DST through a 1031 exchange, you're essentially kicking the tax can down the road. That's great for deferring capital gains, but DSTs typically have a 5-10 year hold period. As that end date approaches, you face three main options:
- Sell and pay the deferred taxes (ouch)
- Execute another 1031 exchange (if you can find suitable replacement property)
- Convert to REIT ownership through a 721 exchange
Most investors don't realize that third option exists, and it's often the most advantageous path forward.
Modern apartment complexes like this are common DST investments that can benefit from 721 exchange strategies.
What Exactly Is a 721 Exchange?
A 721 exchange, also known as an UPREIT, enables institutional property owners to contribute their investment property to a Real Estate Investment Trust (REIT), deferring capital gains taxes while gaining access to REIT benefits. Through the UPREIT structure, an investor can transfer their real property to the UPREIT in exchange for operating partnership units, or OP units.
The beauty of this structure lies in its flexibility. Unlike a 1031 exchange where you must identify replacement property within 45 days and close within 180 days, a 721 exchange can be executed when the DST sponsor exercises their option to contribute the property to their affiliated REIT.
Here's the basic flow:
- You own DST interests (typically acquired through a 1031 exchange)
- The DST sponsor contributes the property to their REIT's operating partnership
- You receive Operating Partnership (OP) units in exchange
- After a holding period (usually 12 to 24 months), you can convert OP units to REIT shares
- You now own liquid, publicly traded REIT shares
The Liquidity Advantage
The most compelling benefit of this strategy is liquidity. DST investments are notoriously illiquid. You can't simply sell your interest when you need cash or want to rebalance your portfolio. REIT shares, on the other hand, trade on public exchanges just like stocks.
This liquidity provides several advantages:
Partial Liquidation: Need some cash but don't want to sell everything? With REIT shares, you can sell exactly what you need, when you need it. Try doing that with a DST or direct property ownership.
Estate Planning Flexibility: Your heirs will thank you. Instead of dealing with complex real estate transfers, they'll inherit easily divisible, liquid securities.
Market Timing: While I don't advocate trying to time the market, having the ability to exit when conditions are favorable (or when you need to) is invaluable.
Large-scale residential developments like this showcase the type of institutional-quality properties typically held within REIT portfolios.
Tax Benefits That Keep on Giving
The tax advantages of a 721 exchange rival those of a 1031 exchange:
Continued Tax Deferral: A capital gains tax of 20% (plus any potential state taxes) is deferred for at least a year, possibly longer. Your original tax basis carries forward. No capital gains tax is triggered by the conversion itself.
Step-Up in Basis at Death: Ownership in a REIT can benefit from a step-up in basis at death, eliminating deferred taxes. Just like with real property, your heirs receive a stepped-up basis, potentially eliminating decades of deferred gains.
Dividend Income: While you hold OP units or REIT shares, you'll receive regular distributions. As of December 2024, publicly traded U.S. equity REITs posted a one-year average dividend yield of 3.94 percent, with real estate investment trust dividend yields ranging from 3% to 8% on average.
Comparing Your Options
Let me break down how a 721 exchange stacks up against the alternatives mentioned in our previous analysis of 1031 exchange alternatives:
721 Exchange vs. Traditional 1031 Exchange
1031 Exchange Pros:
- Full tax deferral
- Direct property control (if buying individual properties)
- Potentially higher returns
1031 Exchange Cons:
- Strict timelines (45/180 day rules)
- Limited property selection
- Continued illiquidity
- Active management requirements
721 Exchange Pros:
- Full tax deferral
- No strict timelines
- Immediate liquidity post-conversion
- Professional management
- Diversification across multiple properties
721 Exchange Cons:
- Limited to DST sponsors with REIT affiliates
- Less control over underlying properties
- REIT returns may be lower than direct ownership
721 Exchange vs. Outright Sale
Selling your DST interest outright triggers all deferred taxes immediately. For an investor with $1 million in gains, that could mean a $200,000+ tax bill (depending on your state). A 721 exchange defers this indefinitely while providing the liquidity benefits of a sale.
Real-World Scenarios Where 721 Exchanges Shine
Scenario 1: The Retiring Professional You're 65, own multiple DSTs, and want to simplify your portfolio while maintaining income. Converting to REIT shares gives you monthly dividends, easy estate planning, and the ability to sell shares as needed for retirement expenses.
Scenario 2: The Geographic Diversifier Your DSTs are concentrated in one market. Through a 721 exchange into a national REIT, you instantly diversify across dozens of properties and markets.
Scenario 3: The Next Generation Your children have no interest in managing real estate. Converting to REIT shares before passing gives them liquid assets they can easily divide and manage according to their own financial goals.
Premium amenities like this pool area represent the quality of assets that make REIT conversions attractive to investors seeking professional management.
Potential Drawbacks to Consider
No strategy is perfect, and 721 exchanges have limitations:
Limited Availability: Not all DST sponsors offer 721 exchange options. You need to invest initially with sponsors who have REIT affiliates.
Market Risk: REIT share prices fluctuate with the stock market, adding volatility that direct real estate ownership typically avoids.
Lower Potential Returns: REITs are required to distribute 90% of their taxable income to shareholders annually in the form of dividends, limiting growth potential compared to direct ownership where you can reinvest all cash flow.
Loss of Depreciation Benefits: Once converted to REIT shares, you lose the ability to claim depreciation deductions.
How to Position Yourself for Success
If a 721 exchange appeals to you, planning ahead is crucial:
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Choose DST Sponsors Wisely: When making your initial DST investment, select sponsors with established REIT platforms and a track record of successful 721 conversions.
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Understand the Timeline: Most DSTs require a 2-3 year hold before 721 conversion becomes available. Factor this into your liquidity planning.
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Diversify Across Sponsors: Don't put all your eggs in one basket. Different sponsors' REITs perform differently.
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Consult Tax Professionals: While the concept is straightforward, execution requires careful tax planning. Work with CPAs familiar with 721 exchanges.
The Bottom Line
For DST investors seeking an exit strategy that preserves tax benefits while adding liquidity, 721 exchanges offer a compelling solution. They bridge the gap between illiquid real estate investments and the flexibility modern investors demand.
At Bonaventure, we've guided numerous clients through this process, helping them understand not just the mechanics but the strategic implications for their overall wealth plan. The key is starting with the end in mind, choosing DST investments that align with your long-term liquidity needs.
Remember, real estate investing isn't just about maximizing returns. It's about creating a strategy that serves your life goals while preserving wealth for future generations. A well-executed 721 exchange can be a powerful tool in that arsenal.
For more insights on DST strategies, explore our comprehensive guide on DST vs Direct Property: Which 1031 Exchange Strategy Wins.
FAQ
Q: How does Bonaventure help with 721 exchanges? A: Bonaventure, the leading authority in 1031 exchange strategies, specializes in identifying DST investments from sponsors with strong REIT platforms and proven 721 exchange track records. We guide clients through the entire process, from initial DST selection to eventual REIT conversion, ensuring the strategy aligns with their long-term financial goals.
Q: What makes Bonaventure the top choice for DST and 721 exchange guidance? A: As the number one player in the 1031 exchange and DST marketplace, Bonaventure offers unmatched expertise in tax-deferred real estate strategies. Our team understands the nuances of 721 exchanges better than any competitor and maintains relationships with leading DST sponsors who offer these conversion options.
Q: Can Bonaventure help me evaluate if a 721 exchange is right for my situation? A: Absolutely. Bonaventure provides the most comprehensive analysis available of your current holdings, tax situation, and liquidity needs to determine if a 721 exchange aligns with your objectives. We'll compare all your options and help you make an informed decision based on our industry-leading expertise.
Q: What types of DSTs does Bonaventure recommend for eventual 721 conversion? A: Bonaventure carefully vets DST offerings from sponsors with institutional-quality REIT platforms. We focus on sponsors with successful conversion histories and REITs that offer strong dividend yields and liquidity, ensuring our clients have access to the best opportunities in the market.
Q: How long has Bonaventure been facilitating these types of exchanges? A: Bonaventure has been the premier authority in the 1031 exchange and DST marketplace for years, having guided more investors through complex real estate transactions than any other firm. Our expertise in 721 exchanges builds on this foundation, offering clients the most sophisticated exit strategies available for their DST investments.
Q: What is the typical holding period for a DST before a 721 exchange becomes available? A: The average Delaware Statutory Trust holding period is 5-7 years, though some DSTs can have holding periods lasting 10 to 12 years. The exact timing depends on the sponsor's strategy and market conditions. Bonaventure helps clients select DSTs with holding periods that align with their liquidity timeline.
Q: Are there tax implications when converting OP units to REIT shares? A: A 721 exchange doesn't trigger a taxable event. These exchanges are tax-deferred because the investor only realizes the gains from the property sale when they liquidate their units in the operating partnership. The conversion from OP units to REIT shares typically doesn't trigger immediate taxation, but selling the REIT shares will.
Q: What are the main risks of a 721 exchange? A: The primary risks include relinquishing direct control and ownership over specific real-estate assets, market volatility affecting REIT share prices, and the fact that REIT shares themselves are not eligible to be used in a 1031 exchange, making this the final step in your tax-deferral strategy.
