What Is a 721 DST and How Does It Work?
Understand the process of exchanging a real estate asset for a passive interest in a larger portfolio, deferring taxes and simplifying estate planning.
A 721 DST transaction is a tax-deferral strategy for real estate investors. It allows an owner of an appreciated property to move from active management to a passive investment without immediately triggering capital gains tax. This is done by exchanging the property for an interest in a professionally managed portfolio of real estate. The structure is designed for long-term wealth preservation and estate planning.
This strategy removes the responsibilities of direct ownership, like managing tenants and maintenance, in favor of holding a security representing an interest in many properties. It allows investors to simplify their holdings, diversify risk, and postpone tax events. The transaction converts a real estate asset into a divisible investment interest while maintaining its tax-deferred status.
Understanding the Core Components
The 1031 Exchange Foundation
The 721 DST process begins with a 1031 exchange, named after Section 1031 of the Internal Revenue Code. This provision allows an investor to sell an investment property and defer capital gains taxes if the proceeds are used to purchase a “like-kind” replacement property. For real estate, “like-kind” is broadly defined, meaning an apartment building can be exchanged for a retail center or another type of investment property.
To execute a valid 1031 exchange, the sale proceeds must be held by a third-party Qualified Intermediary. From the date of sale, the investor has 45 days to identify potential replacement properties and 180 days to close on the purchase.
The Delaware Statutory Trust (DST)
A Delaware Statutory Trust (DST) is a legal entity that holds title to real estate properties. An interest in a properly structured DST is considered a direct interest in the underlying real estate, making it a “like-kind” property that qualifies as a replacement in a 1031 exchange. This allows investors to pool funds and acquire a fractional interest in large, institutional-quality properties.
IRS Revenue Ruling 2004-86 clarified that for this to apply, the DST must meet certain requirements that restrict the trustee’s powers. For instance, the trustee cannot raise new capital or acquire new properties after the offering is closed, ensuring the trust remains a static investment.
The UPREIT Structure
An Umbrella Partnership Real Estate Investment Trust (UPREIT) is a structure used by many Real Estate Investment Trusts (REITs), which are companies that own income-producing real estate. The UPREIT structure has two tiers: the publicly-traded REIT and a subsidiary called an Operating Partnership (OP), which holds the property portfolio.
This design allows the REIT to acquire properties in a tax-efficient way. Property owners can contribute their real estate directly to the Operating Partnership in exchange for an interest in the OP, avoiding an immediate taxable sale.
Operating Partnership (OP) Units
Operating Partnership (OP) units are the securities an investor receives when contributing property to an UPREIT’s Operating Partnership. These units represent an interest in the OP and its entire portfolio of properties. The value of OP units is designed to mirror the value of the publicly-traded REIT shares, and their holders receive distributions equivalent to the dividends paid to REIT shareholders. The primary purpose of receiving OP units is to complete a tax-deferred contribution of property under Section 721 of the tax code.
The Two-Step Transaction Process
Step 1 The Initial 1031 Exchange
The process begins when an investor sells their investment property, often called the “relinquished property.” The sale must be structured as a 1031 exchange, which requires using a Qualified Intermediary (QI) to hold the sale proceeds and prevent the investor from taking control of the funds.
Following the established 1031 exchange timelines, the investor formally identifies an interest in one or more DSTs as the replacement property. The transaction is completed when the investor uses the exchange funds held by the QI to purchase the DST interest.
Step 2 The 721 Contribution Event
After an investor has held their DST interest for a period, typically one to two years, the second phase may occur. This step is initiated by the DST’s sponsor, which is often affiliated with a REIT. The REIT’s Operating Partnership will make an offer to acquire the property held by the DST.
If the offer is accepted, the DST contributes its real estate asset to the UPREIT’s Operating Partnership. In return, the DST receives OP units, which are then distributed to the individual investors. This converts their interest in the trust into a partnership interest in the UPREIT’s OP, a tax-free event under Internal Revenue Code Section 721.
Post-Transaction Ownership of OP Units
Tax Reporting and Basis
After the 721 exchange, the investment’s tax reporting changes. Instead of reporting rental income on a Schedule E, the investor receives a Schedule K-1 from the Operating Partnership. The K-1 reports the investor’s share of the partnership’s income, deductions, and credits for their personal tax return.
The original low tax basis from the relinquished property is carried over first to the DST interest and then to the OP units. This means the deferred capital gain remains embedded in the OP units, awaiting a future taxable event.
Liquidity and Conversion
OP units are not traded on a public stock exchange, making them illiquid. However, the partnership agreement with the UPREIT specifies that OP units are convertible into shares of the parent REIT, usually on a one-for-one basis. This conversion right is often subject to a holding period of a year or more after the 721 transaction.
When an investor chooses to convert their OP units into REIT shares, that conversion is a taxable event. This action concludes the tax deferral, and the investor will recognize the capital gain. The gain is calculated as the difference between the market value of the REIT shares and the investor’s carryover basis in the OP units.
Estate Planning Implications
A significant benefit of this strategy relates to estate planning. If the investor holds the OP units for the remainder of their life, upon their death, the tax basis of the units is “stepped-up” to their fair market value. This step-up in basis eliminates the deferred capital gain that was built up over the investor’s lifetime.
The investor’s heirs inherit the OP units with a new, high tax basis, allowing them to convert the units to REIT shares and sell them with little to no capital gains tax liability.