How Does 721 Exchange Work? Everything You Need to Know

Selling an investment property often comes with a big tax bill. But what if you could defer those taxes and still keep a stake in real estate? That’s exactly what a 721 exchange allows.

With this strategy, you can trade your physical property for shares in a REIT—giving you access to a diversified portfolio while avoiding the headaches of direct ownership and enjoying tax deferral. 

Let’s explore how it works and whether it’s right for you.

How Does 721 Exchange Work? 

A 721 exchange, also known as an UPREIT (Umbrella Partnership Real Estate Investment Trust) transaction, allows real estate investors to convert their property holdings into shares of a Real Estate Investment Trust (REIT) while deferring capital gains taxes.

This process happens in two primary steps:

1. A 1031 Exchange into a Delaware Statutory Trust (DST)
2. A 721 Exchange into REIT Operating Partnership (OP) Units

It is important to note that a 721 exchange is not guaranteed—REITs have the discretion to acquire DST assets, but investors should not assume that an exchange will occur. Now, let’s break the 721 exchange process down step by step.

Step 1: 1031 Exchange into a DST

A 1031 exchange is a well-known strategy that allows investors to defer capital gains taxes by reinvesting the proceeds from a sold property into another qualifying real estate investment. In this case, instead of purchasing another physical property, the investor acquires fractional ownership in a Delaware Statutory Trust (DST).

What Happens in This Step?

1. Investor Sells Their Investment Property
   • The investor sells their real estate (a rental property, commercial asset, or other investment property).
   • They defer capital gains taxes by using the proceeds to complete a 1031 exchange.
2. Investor Acquires Ownership in a DST
   • Instead of purchasing a new physical property, the investor acquires a fractional interest in a DST.
   • The DST is a passive real estate investment vehicle where multiple investors own shares in an institutional-quality property portfolio.
   • The investor has no landlord responsibilities—all management is handled by the DST sponsor.
3. Investor Begins Receiving Passive Income
   • The investor receives quarterly distributions from the DST.
   • The amount received depends on the cash flow of the underlying properties.
4. Holding Period in the DST
   • The investor typically holds the DST investment for at least two years, though the actual timeline may vary based on market conditions and sponsor decisions.
   • During this period, the REIT’s Operating Partnership (OP) may choose to exercise its option to acquire the investor’s DST shares.
   • If this happens, the investor transitions into Step 2: The 721 Exchange Process.

Step 2: 721 Exchange into REIT Operating Partnership (OP) Units

After holding the DST investment for at least two years, the REIT’s Operating Partnership (OP) may exercise its option to purchase the DST assets, allowing for potential tax deferral. If this occurs, the investor’s beneficial interest in the DST converts into operating partnership units in the REIT’s operating partnership, which can be advantageous for estate planning.

What Happens in This Step?

1. Investor Exchanges DST Shares for OP Units
   • The REIT’s Operating Partnership exercises its Fair Market Value (FMV) Option to acquire the DST’s properties, which can have favorable tax consequences.
   • Investors in the DST receive Operating Partnership (OP) Units in return for their fractional DST ownership.
2. Ownership in a Diversified REIT Portfolio
   • The investor now owns operating partnership units, which provide fractional ownership in the REIT’s entire portfolio of properties, offering significant tax advantages.
   • This portfolio consists of institutional-grade, professionally managed real estate across multiple asset classes and locations.
3. Investor Begins Receiving Monthly Distributions
   • Unlike the DST, which may provide quarterly distributions, REIT OP Units may offer distributions, which are subject to the REIT’s performance and management decisions.
   • This income comes from rental revenue and property appreciation in the REIT’s portfolio.
4. Mandatory One-Year Holding Period
   • The investor must hold OP Units for at least one year before making any changes.
   • During this time, the investment continues to generate passive income and potential capital appreciation.

Step 3: Investor's Options After the One-Year Holding Period

Once the one-year holding period for operating partnership units is complete, the investor can choose from the following options for tax deferral:

Option 1: Hold OP Units and Continue Receiving Income

• The investor can retain OP Units indefinitely.
• As long as the investor holds OP Units, they continue receiving passive income distributions.
• The value of OP Units may fluctuate based on the REIT’s performance and market conditions

Option 2: Convert OP Units into REIT Common Shares or Cash

• The investor can convert OP Units into REIT Common Shares if they prefer liquidity.
• REIT Common Shares can be traded on the stock market (if the REIT is publicly listed), providing more flexibility.
• Alternatively, the investor can redeem OP Units for cash, though this would trigger capital gains taxes on the amount sold.

Option 3: Sell OP Units or REIT Shares

• The investor may choose to sell OP Units or REIT Common Shares at any time after the holding period.
• If sold, capital gains taxes apply on the amount sold within the tax year.
• However, if OP Units or REIT Shares are held until passing, the investor’s heirs receive a step-up in basis, potentially reducing future tax liabilities.

Note: Once an investor converts their DST interest into REIT OP Units via a 721 exchange, they are no longer eligible to participate in a future 1031 exchange. This is an important consideration for those who may want to continue deferring taxes indefinitely through 1031 exchanges.

Is a 721 Exchange Right for You?

A 721 exchange is a powerful wealth-building tool for real estate investors who want to transition from direct ownership to passive investing while deferring taxes.

However, it’s not for everyone. Investors who value direct control, frequent 1031 exchanges, or immediate liquidity should weigh the risks carefully. If your goal is diversification, passive income, and long-term tax efficiency, a 721 exchange into a REIT’s OP Units may be an excellent option.

Thinking about a 721 exchange? Contact us now to see if it’s right for you!