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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.
Using Delaware Statutory Trusts (DSTs) in a 1031 Exchange to 721 Exchange & 721 UPREIT
- A REIT creates a temporary Delaware Statutory Trust (DST), allowing 1031 exchangers to purchase or invest in the DST under section 1031.
- After a safe harbor period of approximately two years, the REIT absorbs the DST into its portfolio utilizing section 721. This makes the 1031 exchanger a temporary DST investor, and the due diligence should be focused on the REIT portfolio instead of the individual temporary DST.
- After process completion, the 1031 exchanger owns the REIT.
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.
- The 721 DST is liquid and available to the investor after approximately three years vs. providing liquidity for only 45 days every 4-10 years with a Traditional DST.
- The 721 DST is a sizeable multi-billion portfolio of institutional quality assets diversified by real estate asset class and geography, thus making both the risks and the returns more predictable vs. the single asset Traditional DST with an average equity raise of under $50 million.
- Once you complete a 1031 exchange into a DST that converts to a REIT, you do not have to do another one.
- Over time, the significantly lower initial and ongoing costs of a 721 DST create significantly more equity or value for the investor than the Traditional DST. See our post “Fees Matter” for details.
- Regulatory Risk. If the 1031 exchange is eliminated, then once a DST expires, the investor will be forced to pay taxes. With the 721 DST, the regulatory risk of 1031 legislation is taken off the table.
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,
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|
|Annual Ongoing Costs||Average||High|
|Asset Class 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|