In the beginning, Section IRS Code section 721 was rarified air. To do a 721 UPREIT, a major REIT had to buy your property. Once they bought your property, they brought it into their REIT and gave you operating partnership units for that REIT. Somewhere along the way, some really smart people figured out a way to purchase a DST property and bring that property and its investors into their REIT. With as little as $250,000, an investor can buy a particular type of DST that converts to a REIT in a few years, thus making the 721 exchange a more democratic and viable option. This type of Delaware Statutory Trust is quickly becoming the most popular DST with good reason.
The IRS code section 721 allows an investor to transfer property held in a like-kind exchange for shares in a Real Estate Investment Trust (REIT) without triggering the 20-30% capital gains tax from a traditional sale. If the REIT is held indefinitely, the beneficiaries receive a step up in basis, thus eliminating the capital gain tax. While in the REIT, the owner receives tax-advantaged income throughout their lives.
One of the many benefits of section 721 exchanges is that they allow investors to increase their investment liquidity and portfolio diversification while deferring the payment of capital gains and depreciation recapture taxes when relinquishing their properties. Furthermore, 721 tax-deferred exchanges generate passive income for investors, allowing them a hands-off approach. At the same time, managers handle the day-to-day decision-making process for the portfolio while communicating about acquisitions, dispositions, and distributions.
Why is the 721 DST more appealing than the Traditional DST? The table at the end sets out the major differences, but, in our experience, what compels investors to go the 721 DST route are just five things since they both can defer and eliminate taxes through the step-up in basis.
Most traditional DSTs hold single asset classes, typically single properties. The expected holding period lasts approximately five to seven years, then is liquidated and carries roughly a 15 percent cost at initial purchase and 5 percent upon disposition or sale. The idea of Traditional DSTs is to defer, rollover, defer, rollover, eventually passing away and avoiding taxes. It was a viable exit strategy until the 721 DST came along.
We like to give 721 DSTs different names based on their function. We sometimes call them Hybrid DSTs; other times, we call them Convertible DSTs; other times, Shape-shifter DSTs, and Final Destination DSTs. Why four names? Because a 721 DST acts precisely like a Traditional DST for approximately the first 2-year period 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, so this hybrid is part Traditional DST, and soon after purchase, it becomes a REIT.
Sera Capital’s IRC 721 advisors still utilize Traditional DSTs for approximately 25 percent of our consulting practice clients as appropriate for the client situation. In comparison, the remaining 75 percent recognize the benefits of the 721 DST. We uniquely positioned ourselves to provide both Traditional and 721 DSTs and Qualified Opportunity Zone funds to steer clients into appropriate solutions among all three, then into specific investments. For more information regarding our 721 Exchange services,
Schedule a 30-minute call with our professional 721 Exchange advisors today.
To see some of the differences between Traditional DSTs and 721 DSTs, please see the table below.
| Traditional DST | 721 DST |
Liquidity | Not Liquid | After ~3 years |
Holding Period | 5-10 Years | Indefinite or Perpetual |
Diversification | Typically, One Property | Hundreds of Properties |
Cost to Enter | ~15% of Equity | <5% of Equity |
Exit Fee | ~2-3% of Equity | No Exit Fee |
Step-Up in Basis | Yes | Yes |
Return Predictability | Average | High |
Annual Ongoing Costs | Average | High |
Asset Class Diversification | No | Yes |
Geographic Diversification | No | Yes |
Can I sell a % interest? | No | Yes |
Tax Reporting | 1099 or Grantor’s Letter | K-1 |
Eligible for 20% QBI | No | Yes |