The Traditional 1031 DST vs The 721 DST

Most Traditional DSTs hold a single asset class, typically just a single property. Their expected holding period is approximately 5-10 years.  They are illiquid and carry a 15%-20% cost to purchase and an additional 2-3% upon exit (we've seen some operators charge 5%+). The only reason to ever invest in a Traditional DST is when executing a 1031 exchange because there are superior investments otherwise.

How were Traditional DSTs used in the past and, unfortunately, still used by those that don’t understand the 721 DST? The dated plan, often referred to as “Swap til you drop,” is the 1031 exchanger buys one or more Traditional DSTs. When they mature at different times in 5-10 years, the investor rolls over the original investment plus the profits, if any, into another Traditional DST.  The investor keeps doing this, “Swapping,” until they eventually pass away, “Dropping,” at which time their beneficiaries receive a stepped-up cost basis, thus avoiding taxes altogether. The idea behind the Traditional DST is to defer, rollover, defer, rollover, eventually pass away, and then avoid taxes. It was a state-of-the-art “exit” strategy until the 721 DST or Next Generation DST came along. Now, in 2024 and beyond, it is as relevant and useful as an old-school flip phone.

Why is Swap til you drop with Traditional DSTs no longer competitive? Because investors have wizened up and now have a better option.  The days of “defer” and paying a 15-20% entry fee, “rollover” and paying a 2-3% exit fee, “defer” and paying another 15-20% entry fee, etc., are over.

While the Traditional DST model is an “exit” planning and estate management tool, the 721 DST or Next Generation DST is more appealing in almost every way. The proof is self-evident.  Today, billions of dollars are invested in public non-listed REITs, and more money is flowing towards that form of ownership daily. Investors are voting with their money by investing their after-tax money into these vehicles, and they do not invest their after-tax money into Traditional DSTs.  This means the Traditional DST, while still an elegant solution, has a better, bigger, stronger rival that, when compared side by side, can’t compete.

Why is the 721 DST or Next Generation DST more appealing than the Traditional DST?

First, let’s find out how one works. We give 721 DSTs different names.  We sometimes call them Hybrid DSTs, other times we call them Convertible DSTs, other times Shape-shifter DSTs, other times UPREITS, other times Final Destination DSTs, and finally, our clients like to refer to them as Next Generation DSTs.  Why so many names?  Because a 721 DST acts precisely like a Traditional DST for the first 2-year period, it’s a hybrid until it shape-shifts or converts into ownership of operating partnership units in a Public Non-Listed REIT. This REIT becomes the investor’s final destination because so many never sell once they are in the REIT, and so this hybrid is part Traditional DST, and soon after purchase, it becomes or shifts to a REIT. It’s a Next Generation DST because the creators took dead aim at the Traditional DST and came up with a superior solution in every way, especially when purchased through exit planning fiduciaries that can combine various strategies with the 1031 exchange to create tax free liquidity.

The question then is which approach is better?  It’s not really a question because it’s already been decided by market participants and investors but it’s worth exploring just for thorough due diligence. Is it better to rollover Traditional DSTs throughout a lifetime or is it better to buy a 721 DST that in approximately two years converts into a REIT? Please note that there are inferior DSTs that convert to inferior REITs after 5 or more years, but that is for a separate discussion.

Let’s analyze key features and benefits, and let’s also understand Sera Capital’s perspective. We still utilize Traditional DSTs for approximately 10% of our consulting practice clients because they still have a valid place if you have a high loan-to-value 1031 exchange. Still, the remaining 90% recognize the benefits of the 721 DST.  We are uniquely positioned to be able to provide both Traditional and 721 DSTs as well as Qualified Opportunity Zone funds and initially steer our clients into the appropriate solution between the three and then into specific investments.  So first, we do general top-down analysis and then bottom-up specifics. Our fee is the same regardless of which solution fits best, so our clients can trust that our advice is non-conflicted.

But let’s again focus on the Traditional Delaware Statutory Trust (DST) vs the 721 Delaware Statutory Trust (DST).

• Diversification - The 721 DSTs we recommend convert to Public Non-Listed REITs that hold as few as 50 diversified properties or as many as 900. They are spread out amongst all the major real estate asset classes and adjust their portfolios as the real estate climate changes. This level of diversification is unattainable with Traditional DSTs. It’s the stock market equivalent of holding a diversified portfolio vs a concentrated one.
• Return Predictability - The 721 DST, because it is diversified, is more likely to provide investors with a “real estate index” rate of return, which is typically in the 7-9% range since inception.  This contrasts with the volatility of returns seen in Traditional DSTs.
• Risk Predictability - The 721 DST, because it is diversified, reduces risk since it is spread out over a large portfolio of holdings. This contrasts with the single property volatility or risk seen in Traditional DSTs. It’s important to note that over the years, several Traditional DSTs have lost 100% of the money invested with them because of the single-property nature of the investment. They are, without a doubt, riskier than the 721 DST.
• Liquidity/Estate Planning - The 721 DST offers investors liquidity after 3 years, and they maintain this liquidity until they die. At this time, they receive a stepped-up cost basis just like the Traditional DST. Liquidity is critical as investors age because often, they are incapable of making the Traditional DST rollover decision due to poor health or mental incapacity. This often ruins decades of tax planning as the investor receives taxable funds upon the sale of the Traditional DST.  Furthermore, with the 721 DST, beneficiaries have immediate full access to the decedent's REIT while they must wait for the Traditional DST to complete its 5–7-year cycle, which often leaves the estate unsettled or creates costly complications.
• Cost or Fees - The 721 DST starts out as a traditional DST and then converts to a Public Non-Listed REIT after approximately 2 years.  The “all in” cost to buy into a 721 DST seldom exceeds 5%, while the “all in” cost of a Traditional DST is approximately 15%-20%.  To make matters worse, the Traditional DST may last an average of 5-7 years, so the 15%-20% fee would need to be paid every 5-7 years, while the 721 DST is a one-time fee.  Lastly, the Traditional DST has approximately a 2-3% exit fee paid to the sponsor plus the cost to transact the exit every time.  This is a significant cost differential, and if you are interested, you, can request our which is the best DST calculator, to understand just how much this will affect your portfolio.
• Regulatory Risk - The 721 DST gets its name from section 721 of the IRS code, just as the 1031 exchange gets its name from section 1031 of the IRS code. Investors in real estate as well as investors in Traditional DSTs will be left with some tough choices and tax consequences should Congress eliminate 1031 exchanges.  The 721 DST eliminates this risk.
• Simplicity and Certainty - The 721 DST is purchased once, and the investor never has to perform an additional 1031 exchange. Some people consider this a negative, but they are typically Traditional DST salespeople without access to 721 DSTs. Sera Capital, as an independent, has access to every type of Traditional and 721 DST and we disagree with the notion that you can’t exit a 721 DST. We have a variety of exit strategies. Furthermore, why would you want to exit if you have made the decision to go from active to passive.  It's a silly idea. The average first-time DST investor is 64 years old and has made the decision to move from active ownership to passive ownership. Once an investor decides to move to passive ownership, they don’t revert to active. While this may be a problem for younger investors, in our practice, we only recommend DSTs if and only if an investor wants out of active management. If they want to stay active, we go out of our way to let them know that perhaps the DST route is not appropriate for them yet.
• Gifting/Charity - The 721 DST, because it is in units and is liquid soon after purchase is often used as an estate planning device to gift highly appreciated assets to children and charities.  This is not possible with Traditional DSTs since they only mature and provide liquidity every 5-7 years while creating a tax problem.
• Retitling - The 721 DST, just like the Traditional DST is often retitled for estate planning purposes. Often titles are held in such a way that the owners want to separate their holdings because they have divergent interests.  With the 721 DST after a 3-year period from the initial purchase, the investors can go their separate ways.  If, for example, there are 2 investors in an LLC, one investor can retain the units and they could be titled in their name or trust while the other could sell their units and pay taxes on the gain or utilize one of our tax efficient exit strategies from the REIT.  This flexibility is not available under the Traditional DST.
• Tax Planning/Tax Savings - The 721 DST lets you sell units after 3 years.  This is particularly useful when combined with a total portfolio perspective. Let’s suppose the investor has a loss from a stock sale or from the sale of another piece of real estate, they can sell the appropriate amount of their Public Non-Listed REIT to utilize this loss.  Thus, they create even greater liquidity and more flexibility.  This is not possible with a Traditional DST.
• Income Supplement - The 721 DST lets you sell after 3 years.  Many investors find themselves in lower tax brackets as they journey through retirement. 721 DSTs allow the possibility of the periodic sale of units to supplement your income at a lower tax rate than on the day of your initial purchase.  This is not available with Traditional DSTs.
• Tax Free Access to Cost Basis – Upon conversion from a DST to the REIT, you do not own shares.  You own operating partnership units.  This is a tremendous benefit because partnerships let you access your cost basis anytime after 2 years. While this may seem like a tremendous benefit, which it is, we have seldom seen it used.  What we do see is investors borrowing against their units at rates that are often more attractive than the cash-on-cash yields on their investment. Nevertheless, it is a valuable option, especially for younger, very aggressive investors such as developers. The ability to access money on a tax-free basis after a period of time has infinite use cases.

To learn more about 721 Exchanges and 721 Delaware Statutory Trusts (DSTs)

Schedule Your Free Call Today or read more about how you can 1031 exchange into a REIT.