A 721 Exchange Is a One Way Door Out of Your 1031 Chain

A 721 exchange is a contribution of property to a partnership in return for an interest in that partnership, with no gain recognized at the time. For most real estate investors it shows up one way. The Delaware Statutory Trust they bought in a 1031 exchange is folded into a REIT's operating partnership, and they end up holding units instead of real estate.

That trade is usually described from the REIT's side. We'd rather describe it from yours, because the decision you're actually making is whether to give up the next 1031.

How a DST ends up as REIT units

The conversion happens because the REIT that sponsors the DST wants the property, and the tax code gives it a way to take it without making you pay tax on the way in.

Section 721 of the Internal Revenue Code says it in one sentence. No gain or loss shall be recognized to a partnership or to any of its partners in the case of a contribution of property to the partnership in exchange for an interest in the partnership. A REIT that's organized as an UPREIT holds its real estate through an operating partnership, so property contributed to that partnership comes in under section 721 and the contributor receives operating partnership units, usually called OP units.

The DST side of this rests on a 2004 ruling. In Revenue Ruling 2004-86 the IRS held that a taxpayer may exchange real property for an interest in a Delaware statutory trust without recognition of gain or loss under section 1031, if the other requirements of section 1031 are satisfied. That's why a DST can be your replacement property in the first place, and it's why the conversion comes later rather than at the start.

In the DSTs we place, the conversion isn't automatic. The option is typically offered to investors about two to three years into the DST, and you decide at that point.

What you keep and what you give up

You keep the deferral and you keep an income stream. What you give up is the exit you've been relying on.

OP units are a partnership interest, and an interest in a partnership isn't real property. So once you hold units, the next move can't be another 1031 exchange. The chain of deferrals you may have been building since your first rental stops there. When you eventually redeem the units for REIT shares or cash, that's a taxable event, and the gain that's been deferred all along comes due.

What you gain is real too. There's no 45 day identification window and no 180 day closing deadline hanging over you ever again. Your money sits in a larger portfolio instead of one building. And REIT shares are generally far easier to sell than a DST interest, which has no resale market at all.

A 721 exchange doesn't end your deferral. It ends your ability to extend it with another 1031, and that's the trade to price before you say yes.

Why the conversion is offered and not automatic

It's offered because it suits the sponsor, and it's optional because it doesn't suit everyone.

A REIT that sponsors DSTs is building its own portfolio. Converting a DST it already manages is an efficient way to acquire a property it knows well, and the investors arrive already familiar with the sponsor. None of that is a problem. It just means the offer is made for the sponsor's reasons, and you should weigh it for yours.

Before you answer, we'd want to know three things. What happens to the DST if you decline? Is the REIT's share price, redemption policy and fee load disclosed clearly enough to compare against simply waiting for the DST to sell? And is there any protection for you if the operating partnership later sells the property you contributed?

That last question matters more than it sounds. Under section 704(c), gain on contributed property is shared among the partners so as to take account of the difference between its tax basis and its value when it came in. In plain terms, your built-in gain stays yours, and if the partnership sells or distributes that property, some of it can come back to you. Section 704(c) also carries a 7 year window for distributions of contributed property to other partners, which is one reason these questions belong in writing before the conversion.

A worked example

Picture Ray and Linda. Three years ago they sold a rental house for $900,000. Their adjusted basis was $300,000 and there was no loan, so they were looking at a $600,000 gain. They exchanged the full $900,000 into a DST and paid no tax.

Now the sponsor is offering to convert the DST into OP units. They have three options.

1. Decline and stay in the DST. When the DST's property sells in a few years, they'll need a new 1031 exchange, with a new 45 day list and a new 180 day deadline, in their mid seventies. They don't like this idea.
2. Convert and hold the units for life. Income continues, the deferral continues, and nobody's chasing a replacement property. Their basis in the units carries over from the DST, because section 722 sets a partner's basis at the adjusted basis of the property contributed. They like this idea.
3. Convert and redeem units a few at a time. Each redemption is taxable, but spreading them across years spreads the tax with them. Their adviser likes this idea more than they do.

Run the numbers again and converting doesn't reset anything. Ray and Linda's $300,000 basis follows them into the units, so if they redeemed all $900,000 worth tomorrow they'd recognize the same $600,000 gain they deferred three years ago.

On top of that comes whatever depreciation recapture has built up. And if they hold the units until death, the picture changes, because under section 1014 property acquired from a decedent generally takes a basis equal to its fair market value at the date of death. That's a conversation for their tax professional, and it's often the real reason the second option wins.

Can you 1031 exchange into a REIT?

No, not directly. REIT shares and OP units are securities and partnership interests rather than real property, so buying them with exchange proceeds isn't a like kind exchange and the gain would be taxed.

The route that works goes through a DST. You exchange your relinquished property into a DST as replacement property within the normal 1031 timeline, and later, if the sponsor offers it and you accept, the DST converts into OP units under section 721. Two steps, two different code sections, and a gap of years between them.

When staying in the DST is the better exit

Staying put is usually right when you still want to trade up, consolidate, or move back into property you manage yourself.

A DST that sells lets you do another 1031 into whatever comes next. That might be a larger building, several DSTs, or a mix of a direct purchase and a DST to make the numbers work. If you're still building, the one way door of a 721 exchange closes an option you'll probably want. And if you'd like cash out without a tax bill at all, a DST sale can also be the starting point for other deferral structures, including a Deferred Sales Trust.

Converting is usually right when you're finished with deadlines, you want the income to keep coming, and the property is likely to be held for the rest of your life. Neither answer is wrong. The mistake is taking the offer by default.

If you've had a conversion offer, or you're choosing a DST now and want to know which ones carry one, book a DST consultation before you sign anything. Our Delaware Statutory Trust page covers how we approach DSTs in general. Thanks, Chris Shockowitz and Carl Worden.

Note. We're not CPAs or tax attorneys. Ray and Linda are a teaching scenario and not real clients. Don't use any of it for your personal financial situation without speaking with a tax professional.

FAQ

What is a 721 exchange transaction?

It's a contribution of property to a partnership in return for a partnership interest, with no gain recognized at the time under section 721. In real estate it usually means property, often held in a DST, being contributed to a REIT's operating partnership in exchange for OP units.

How does a 721 exchange differ from a 1031 exchange?

A 1031 exchange swaps real property for other real property and keeps you in real estate. A 721 exchange swaps property for a partnership interest, so you come out holding OP units rather than a building. You can go from a 1031 into a 721, but not back, because OP units can't be exchanged under section 1031.

What types of properties qualify for a 721 exchange?

Section 721 applies to property contributed to a partnership, so the tax rule itself is broad. In practice the REIT decides what it will accept, and it wants property that fits its portfolio. For most individual investors the realistic path is a DST sponsored by a REIT that later offers a conversion.

What is the downside to a 721 exchange?

You lose the ability to do another 1031 exchange with that money. Redeeming your units is taxable, your deferred gain stays attached to you, and you're concentrated in one REIT's portfolio and fee structure. If the partnership sells the property you contributed, some of your built-in gain can come back to you.