A Comprehensive Review of Potential Benefits, Risks, and Structural Considerations

By Rena Morris, Registered Representative, Emerson Equity | Irvine Advisors, LLC

[Editor’s Note: A 721 exchange (“UPREIT”) allows real estate investors the option to contribute appreciated investment property or Delaware Statutory Trust (DST) interests into a real estate investment trust’s (REIT’s) operating partnership in exchange for Operating Partnership (OP) units. This strategy defers capital gains and depreciation recapture taxes under IRC Section 721.]

Real estate investors have become increasingly familiar with implementing 1031 Exchanges into passive ownership of property through vehicles such as a Delaware Statutory Trust (DST). Investors would benefit from understanding those DSTs which offer or require a 721 exchange into a REIT which owns Operating Partnership (OP) units, operated by the same sponsor, when the REIT acquires their interest in the DST.

As with all things, there are both positive and negative characteristics and the intent of my article is to identify those qualities, enabling investors to make a considered decision as to whether to exchange into a DST that offers, and sometimes requires, a mandatory conversion from the DST to an Operating Partnership (OP) owned by their REIT.

Overview and Potential Benefits

A 721 exchange — also known as an UPREIT (Umbrella Partnership Real Estate Investment Trust) transaction — allows investors holding Delaware Statutory Trust (DST) interests to convert those interests into OP units in typically a non-traded REIT, deferring capital gains tax in the process. While this structure offers meaningful estate planning and diversification advantages, it also carries valuation, liquidity, and structural differences that investors should evaluate. Potential benefits include:

1. Estate Planning and Divisibility. DST interests and OP units are divisible in ways that directly owned real estate is not. This may reduce the risk of family disputes over property management or forced sales. If an investor holds OP units until death, like other real estate except that held in an Irrevocable Trust, heirs may receive a step-up in cost basis under current law — potentially eliminating decades of deferred capital gains and depreciation recapture.

2. Exit from 1031 Treadmill. For investors who have cycled through multiple 1031 exchanges, the 721 conversion represents a permanent exit from the 45-day identification and 180-day closing deadlines. The trade-off is there are no more exchange cycles that create recurring transactional friction and force purchase decisions under time pressure.

3. Broader Portfolio Diversification. As a DST investor you are already in a passive ownership role, but your exposure is concentrated in a single property or small pool of assets. After a 721 conversion, your interest shifts into a REIT portfolio that may hold dozens of properties across multiple geographies — broadening the underlying asset base.

4. Incremental Tax Recognition. Once an investor holds OP units, those units may be partially redeemed incrementally over multiple tax years rather than all at once. This allows for more deliberate gain recognition and potential tax planning flexibility. Investors should confirm whether the specific operating partnership agreement permits staged conversion before relying on this feature and also note that liquidity features may be altered or suspended by the Board.

5. Potential for Appreciation. REITs can raise capital through various means, which provides additional funding for property acquisitions or other strategic developments, potentially increasing the value of the partnership units over time.

Some of the Potential Risks

There are also some potential risks associated with the 721 exchange. These include:

1. Valuation. Because the sponsor often controls both the DST and the acquiring REIT, 721 exchange transactions may lack the arms-length negotiation to establish fair market value. Perpetual-life REITs typically use book values (assessed Net Asset Valuations or NAVs) rather than market-driven values (market values). The NAV assessment process may result in overvaluation.

2. Fee Crossover. 721 conversions may be marketed with lower upfront loads than traditional DSTs. However, ongoing REIT-level asset management fees — typically 1.0 — 1.25% of NAV annually — compound for as long as the investor holds OP units and the total load on equity may exceed that of a traditional DST by years 7–8 of OP ownership

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3. Liquidity Caps and Prorations. Most non-traded REIT redemption programs cap aggregate redemptions at 5% of NAV per quarter (often 2% per month). These are aggregate caps across the entire shareholder base. When redemption requests exceed the cap, the requests are prorated. The redemption policy may change or be eliminated at the Board’s discretion.

4. Loss of 1031 Eligibility. When using a 721 exchange, the investor’s DST interests convert to OP units automatically. OP units are classified as personal property and unless the classification is changed through a substantial structural reorganization, they cannot be used in a future 1031 exchange.

5. Tax Protection Gaps. If the REIT sells a contributed asset at any time, it may trigger gain recognition for the original contributor. Some, but not all, 721 REIT operating partnership agreements include built-in gain protection for contributed properties, and the protection may not be in place the entire holding period.

Investor Guidance

To thoroughly evaluate the benefits and risks associated with a 721 exchange, my advice would be to take the following steps before committing to an UPREIT transaction:

• Review the Private Placement Memorandum (PPM) Thoroughly. Review the Private Placement Memorandum (PPM) of the DST and REIT to identify the valuation methodologies, associated fees and liquidity.
• Vet Sponsor Quality. Assess the DST / REIT sponsor’s track record, management quality, alignment of interests with investors, and history of managing non-traded redemption programs, particularly during periods of market stress.
• Understand the OP Agreement. Confirm whether the operating partnership agreement includes built-in gain protection, and whether staged conversion of OP units to REIT shares is permitted.
• Align with Personal Liquidity Needs. Compare the benefits and risks and seek to align your decision with your investment goals, timeline, and estate planning goals.

This document is for informational purposes only and does not constitute investment, tax, or legal advice. Consult qualified professionals before making any investment decision. The following 1031 Risk Disclosure is being made:

• There is no guarantee that any strategy will be successful or achieve investment objectives;
• Potential for property value loss – All real estate investments have the potential to lose value during the life of the investments;
• Change of tax status – The income stream and depreciation schedule for any investment property may affect the property owner’s income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities;
• Potential for foreclosure – All financed real estate investments have potential for foreclosure;
• Illiquidity – Because 1031 exchanges are commonly offered through private placement offerings and are illiquid securities. The secondary market for these investments is very limited, and early sale is not guaranteed.
• Reduction or Elimination of Monthly Cash Flow Distributions – Like any investment in real estate, if a property unexpectedly loses tenants or sustains substantial damage, there is potential for suspension of cash flow distributions;
• Impact of fees/expenses – Costs associated with the transaction may impact investors’ returns and may outweigh the tax benefits

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