The Pros and Cons of 721 Exchanges vs DSTs

Is the glass half empty or half full?

Recently, there has been a lot of talk with respect to changing the IRS tax code.  It seems every possible change is part of the conversation and runs the gamut from increasing corporate taxes to eliminating stepped up cost basis to reducing estate tax exclusions and eliminating the 1031 exchange.  The conversation of course is part of the debate centered around the notion that the “wealthy” don’t pay their fair share on one hand vs the “wealthy” provide the fuel to the economy and you must continue to incent them.  This debate is older than I am and regardless of which side of the debate you favor, in a nutshell it simply deals with self-governance.  I think we’ve found a very good balance over the last 200+ years and I am confident we will continue to move forward positively.  What’s peculiar about the debate is that no mention is made of what the “wealthy” will do should 1031 exchanges be eliminated or limited in dollar amount.  Here’s what I think they will do and it’s a bold prediction-they will stay wealthy.  They will utilize advisors such as our firm and others and they will find ways to keep their money on their side of the ledger instead of the government’s side of the ledger.  Why?  It’s because that’s what wealthy people have always done and will always do.  Enter the 721 Exchange or UPREIT.

The 721 Exchange or UPREIT doesn’t seem to be part of the conversation because it plays such a small role in the economy.  But that will change and is changing and thus the reason for this post.  While it seems lawmakers have no interest in addressing this section of the IRS code since it is so seldom used in everyday life, the same can’t be said for investors and the companies or sponsors that can facilitate these types of transactions.  What we see is that a few clever and innovative institutional real estate powerhouses have found innovative ways to let even the smallest of accredited investors participate in the 721 Exchange process which was once not possible.  It is at this time that 99.5% of investors will have lost interest in this post because we will be getting deep into inside baseball aspects of 1031 exchanges that just don’t apply to most people.  But if you happen to be one of the 0.5% where this does apply, you should read the rest of this post carefully because it could be valuable.  That said, the rest of this post assumes you are familiar with 1031 exchanges and have at least a peripheral understanding of what a 721 exchange might look and feel like once you own one.

As our readers know, we like to tell tales and our book Financial Tales is filled with them.  Our tales are designed to be evergreen so that decades from now the lessons learned can be applied even if the circumstances have changed and so we like to have a subtitle that speaks to that lesson.  In this case, Is the glass half empty or half full, is the lesson to be learned.  Let us tell you what happens on a weekly basis at our firm.

We receive a call from an experienced and successful real estate investor that is looking to move from active management to passive management and wants to understand our services and value proposition.  We go through our song and dance and if applicable, eventually get to the point where we explain where the 721 option may fit in for them.  Here’s what we hear, “I will never ever, ever, ever, ever be part of a 721 exchange, there is no way I am giving up my ability to do future 1031 exchanges.”  Here’s what else we hear, “I had no idea this was possible, you mean I can do this one-time exchange and never have to do another one and on top of it I end up with a larger more diversified portfolio, sign me up.”  So, is the glass half empty or half full?  It is not our job to inject our opinion into the situation but to simply explain, we can see the merits of each.  If asked our opinion, we would come down as we seem to always do somewhere in the middle.  We see value in both sides of the debate and when asked for our specific opinion, we recommend that our clients allocate as much as 40% of their 1031 exchange to DSTs that will convert via the 721 Exchange to a privately traded REIT.

So, what’s the person that will never do a 721 exchange see that makes them shun it?  In a nutshell it’s one and only one feature or problem.  The problem with 721 exchanges is that once you are in one, you can never do another deferred tax exchange which implies that you must be comfortable with the management at the ultimate REIT destination because you are married with this REIT for life.  Please note, we have developed a number of 721 exit strategies that can mitigate the risk of ending up in a poorly managed REIT.      

So, what’s the person that embraces a 721 exchange see that makes them attractive?  In this case---it’s everything else.  The benefits far outweigh the lost opportunity to do potential 1031 exchanges.  Here’s what you get,

• An actively managed and diversified REIT portfolio instead of the typical single asset investment associated with a traditional DST.
• Higher expected rates of return since the DST design is typically far less risky and offers lower expected returns than the REIT.
• Better tax efficiency on annual income since REITs can take advantage of certain tax provisions that are unavailable to DSTs which means more after-tax income to the investor.
• Regulatory risk hedging. Should 1031 exchanges cease to exist, you will be safely invested in a 721 Exchange and need not worry again.
• This is a valuable benefit because it makes estate planning easier, gifting easier, tax loss harvesting easier and provides emergency access to your money.
  1. Estate planning is easier because upon death you receive a stepped-up cost basis just like DSTs do but instead of no liquidity as is the case with a DST, the REIT provides immediate liquidity.
  2. Gifting is easier because you can gift units/shares far easier than you can change beneficial ownership interests.
  3. Tax loss harvesting is easier because it’s possible with a REIT and not possible with a DST. If you have a capital loss from other investments outside the REIT you can use it to offset the capital gains incurred from selling REIT units.
  4. This is obvious but worth stating, you can liquidate all or any portion of your 721 REIT after the 3 year cooling off period.

In closing this post, I would like to offer my view of the future.  The 721 is going to become the dominant ultimate destination of 1031 exchange funds for the individual investor as more and more high-quality players enter the arena.  We have looked at a number of players and at this time only recommend 2, which is why we only recommend a 40% maximum allocation to this space at this time.  We expect that our allocation will increase to as much as 100% in some cases as the field of qualified opportunities expand.

Update: We now recommend 3 721 DST sponsors.

Read more about how you can 1031 exchange into a REIT.