A Comprehensive Guide to the 721 Exchange UPREIT Exit Strategy for Delaware Statutory Trust Investors

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Delaware Statutory Trusts offer a structured investment vehicle for those looking to own real estate passively. Established under Delaware law, a DST is a legal entity that holds real estate on behalf of multiple investors, allowing them to pool their resources without assuming active management responsibilities. The trust is managed by professional trustees who oversee operations, ensuring compliance with IRS regulations while generating passive income for investors.

A key advantage of DSTs is their eligibility for 1031 exchanges, which allow investors to defer capital gains taxes when reinvesting proceeds into like-kind properties. DST investors also benefit from limited liability, meaning their personal assets are protected from potential financial obligations associated with the trust. This structure provides a convenient way to invest in real estate without the complexities of direct ownership.

Full-Cycle Events in DST Investments

All DST investments have a certain lifespan – often 4 – 8 years before running “full-cycle”, a term that describes a DST property that is purchased on behalf of investors and then, after a period of time, is sold on behalf of investors. 

Once a DST investment reaches full cycle, investors often, but not always, have several options for reinvesting their proceeds. First, they can take the cash distribution and trigger an immediate taxable event. Second, they can enter another 1031 exchange, rolling their sale proceeds into another 1031 exchange eligible real estate investment, including a new DST. The third is transitioning to a 721 Exchange UPREIT, if offered to them as an exit strategy, which provides access to a REIT structure with liquidity advantages and long-term investment potential. 

Obviously, choosing the right exit strategy is a crucial decision for Delaware Statutory Trust (DST) investors, and clearly understanding the options potentially helps provide a smooth transition while avoiding a potentially expensive tax consequence. 

More and more, investors are using the 721 Exchange UPREIT as an investment strategy following a Full-Cycle event. The 721 Exchange UPREIT allows investors to convert their real estate holdings into operating partnership units within a Real Estate Investment Trust (REIT). This approach enables tax deferral, provides liquidity options, and enhances portfolio diversification, making it an attractive choice for investors seeking a strategic exit from their DST investment.

A Closer Look at the 721 Exchange UPREIT 

The 721 Exchange is a tax-deferred strategy governed by Section 721 of the Internal Revenue Code. This provision allows property owners to contribute real estate assets into an operating partnership within a REIT in exchange for Operating Partnership Units (OP Units). Unlike a traditional sale, which triggers capital gains taxes, a 721 Exchange enables investors to defer taxes while retaining an economic interest in a diversified real estate portfolio.

An Umbrella Partnership Real Estate Investment Trust (UPREIT), is the structure through which this exchange occurs. In an UPREIT, the REIT forms an operating partnership that acquires properties in exchange for OP Units. These units function similarly to shares in a REIT, providing investors with income distributions and potential appreciation. The primary advantage of a UPREIT is that it allows investors to transition from direct property ownership into a diversified real estate portfolio without immediate tax consequences.

By participating in a 721 Exchange, investors gain exposure to professionally managed, income-generating properties while deferring capital gains taxes. This strategy enhances portfolio flexibility and provides an alternative to reinvesting in another DST or individual property. Understanding the benefits and considerations of this strategy is key for investors evaluating their next steps after a DST full-cycle event.

Benefits of the 721 UPREIT Exit Strategy

“One of the most significant advantages of the 721 Exchange is the ability to defer capital gains taxes,” says Dwight Kay, Founder and CEO of Kay Properties and Investments. “Typically, selling a DST property, without conducting a subsequent 1031 or 721 exchange, triggers taxes on any appreciation and depreciation recapture. However, by converting the property into OP Units within a UPREIT, investors can postpone these tax obligations and potentially preserve capital for reinvestment.”

It is important to note that these operating partnership units have economic rights that are often identical to the rights of the shares of the REIT, and after a designated holding period can be, if the investor chooses to, converted into shares of the REIT (in a taxable transaction) for potential liquidity purposes. 

Investors seeking to defer capital gains taxes while increasing diversification in real estate should consider using a 721 Exchange to realize the following potential benefits. 

Tax Advantages – When real estate is typically sold, the investor pays taxes on the capital gains realized as well as depreciation recapture. This leaves the investor with less capital for reinvestment. With the 721 Exchange, the investor can avoid this hefty tax through a tax-deferred exchange of appreciated real estate for shares in an operating partnership. These operating partnership units are also known as OP Units. 

Capital gains can be deferred until the investor sells the OP Units, converts the OP Units to REIT shares, or the contributed property is sold by the acquiring operating partnership. 

Diversification – Many investors incur concentration risk by owning one property in a single market. REITs tend to own many assets diversified through different markets. The 721 Transaction into a REIT can provide greater diversification for an individual’s portfolio, which may reduce concentration risk.

Income Potential – Investors will potentially receive income generated through distributions to the holders of the OP Units. 

Liquidity – The ability to convert OP Units of the REIT to shares can provide potential liquidity benefits that are not standard with DST or property ownership. Partial or full liquidity may be achieved, potentially depending on availability determined by the company, by converting the OP Units to shares of the REIT. However, it is important to note that the REIT may shut down liquidity at their discretion, so there is no guarantee of liquidity.

Estate Planning – Upon death, shares can be equally split and either held or liquidated by the beneficiaries of the trust. Because these shares are passed through a trust, the beneficiaries receive a step-up basis and can avoid capital gains taxes and depreciation recapture. 

One important caveat for investors interested in 721 Exchanges is that REIT shares themselves are not eligible to be used in a 1031 Exchange, and therefore, once a 721 Exchange is completed, this is the end of the line for deferral of capital gains taxes. If the shares of the REIT are sold, or the REIT sells a portion of the portfolio and returns the investor’s capital, the investors will be required to recognize any capital gains or losses when they file their taxes. For this very reason, many investors have decided that they did not want to participate in a DST that had a forced 721 UPREIT exchange, as they wanted the opportunity to complete a future 1031 exchange at their discretion.

The Importance of Performing Due Diligence Before Committing to a 721 Exchange

Investors considering placing a large amount of their total net worth should perform a thorough due diligence process prior to investing. Too often, financial advisors and so-called experts recommend plopping an entire client’s 1031 exchange into a single 721 UPREIT DST without thoroughly examining these critical economic indicators. Investors must understand the nuances of the DST’s underlying REIT, including markups, debt structure, dividend coverage, and net capital flows.

Kay Properties regularly performs a deep review and analysis of all real estate assets prior to allowing them on our online marketplace located at www.kpi1031.com. 

Some of the specific areas investors need to be aware of prior to investing in a 721 UPREIT include: 

Understanding Valuation and Markups

Investors should ask whether the REIT has marked up the DST they’re investing in—and if so, by what percentage. Often, these REITs already own a property and then sell it to the DST at a significantly marked-up price, sometimes exceeding 20%. All financial advisors and wealth managers are ensuring investors that there are no to minimal fees – a massive misrepresentation. However, a significant markup can indicate an overvalued asset and the presence of hidden fees.

Disclosure of Markups in Private Placement Memorandums (PPMs):

While the fine print of the Private Placement Memorandum (PPM) discloses these markups, the estimated use of proceeds page typically omits them. This omission makes these fees harder to track and understand, especially compared to traditional Delaware Statutory Trust (DST) offerings, which usually disclose all costs directly on the PPM’s estimated use of proceeds page. This discrepancy can lead to misaligned expectations and increased risks over time for 721 UPREIT DST investors.

Assessing Debt Levels and Interest Rate Exposure

It’s crucial to examine the REIT’s debt profile. Investors need to know the total debt and how much of that debt is floating or adjustable. A heavy reliance on adjustable-rate debt can expose the REIT to interest rate volatility, increasing the risk of higher future costs and impacting overall financial stability. Many 721 UPREIT opportunities are tied to REITs that carry substantial borrowings, while other available opportunities remain debt-free with no loans. Investors must decide whether they are more comfortable with large amounts of debt (many variable-rate debt) or with a debt-free opportunity with no financial leverage risks.

Dividend Coverage and the True Yield – A Critical Measure for 721 Exchange UPREIT Investors

A key indicator of a REIT’s financial health is its dividend coverage, measured by Adjusted Funds from Operations (AFFO). Suppose the AFFO coverage is less than 100%. In that case, it means the REIT is not fully supporting its operational income dividend and instead relies on borrowings or fresh investor capital. This practice raises a red flag because it introduces systemic risk: relying on external funding to sustain a portion of the dividend rather than genuine operating performance jeopardizes the dividend’s sustainability. Investors must avoid making critical decisions based solely on their relationship with a financial advisor or the REIT company’s glossy brochures and impressive size and scale. Instead, they should base their decisions on the REIT’s actual financial performance.

Net Inflows and Capital Movements

Beyond debt and dividend metrics, investors should also review the REIT’s net capital flows. For example, if a REIT raises $50 million in fresh capital but experiences redemptions and outflows totaling $200 million over the same period, resulting in a net outflow of $150 million, this discrepancy could indicate deeper financial challenges. Such a pattern might signal that the REIT is facing liquidity issues that could jeopardize future distributions.

About Kay Properties and www.kpi1031.com: 

Kay Properties helps investors choose 1031 exchange investments that help them focus on what they truly love in life, whether that be their children, grandkids, travel, hobbies, or other endeavors (NO MORE 3 T’s – Tenants, Toilets and Trash!). We have helped 1031 exchange investors for nearly two decades exchange into over 9,100 – 1031 exchange investments. Please visit www.kpi1031.com for access to our team’s experience, educational library, and our full 1031 exchange investment menu.

This material is not tax or legal advice. Please consult your CPA/attorney for guidance. Past performance does not guarantee or indicate the likelihood of future results. Diversification does not guarantee returns and does not protect against loss. Potential cash flow, potential returns, and potential appreciation are not guaranteed. There is a risk of loss of the entire investment principal. Please read the Private Placement Memorandum (PPM) for the offerings business plan and risk factors before investing. Securities offered through FNEX Capital LLC member FINRA, SIPC.