1031 Exchange Blog

How Does a 721 DST Work?

A 721 DST is a multi-step process. It begins with the sale of the investor’s original property and can ultimately result in ownership tied to a broader REIT portfolio.

Step 1: Sell the Original Property

As with any 1031 exchange, the first step is to sell the investor’s original property, or, in 1031 exchange terminology, the relinquished property.

An investor would generally sell the property through the local real estate agent or broker of their choosing, just as they would with any traditional real estate sale.

The key difference is what happens with the proceeds at closing.

Before the property closes, the investor will need to establish an exchange account with a Qualified Intermediary, commonly referred to as a QI. When the relinquished property sells, the proceeds are transferred directly from escrow to the Qualified Intermediary.

The investor cannot take possession of the funds. If the investor receives or has control over the sale proceeds, the transaction may no longer qualify as a 1031 exchange and could become a taxable event.

For that reason, the Qualified Intermediary should be established before the relinquished property closes.

Set up your Qualified Intermediary before the sale closes. If you receive or control the proceeds, the exchange may become a taxable event.

Step 2: Start the 1031 Exchange

Before selecting a Qualified Intermediary, investors should perform due diligence on the company they plan to use, including:

• How funds are held
• Bonding and insurance protections
• Internal safeguards
• The firm’s overall reputation and experience

Once the relinquished property closes, the sale proceeds are transferred into the Qualified Intermediary account and remain there during the exchange process.

The 1031 exchange timelines begin on the date the relinquished property is sold. The two deadlines investors need to remember are the 45-day identification period and the 180-day exchange period.

During this period, the investor can evaluate potential investments, conduct due diligence and determine how they want to structure the exchange.

Step 3: Purchase the DST

Purchasing a DST follows a process similar to buying any other real estate asset in a 1031 exchange. The difference is that instead of buying the asset directly, your exchange proceeds go to the DST sponsor.

When you invest in a DST, you will complete subscription documents. Upon closing, you will be assigned your pro rata share of the investment.

For example, if you invest $1 million into a $100 million property, you would be a 1% owner, and your closing statement would reflect that ownership interest.

In DSTs that have debt, you will also be assigned your pro rata share of the debt. Using that same example, if the deal were 50% leveraged and you invested $1 million, you would also be assigned $1 million of debt at closing. In that case, you would effectively be purchasing $2 million of real estate.

When purchasing the DST, you must still follow the same 1031 exchange timelines. You must identify the DST by Day 45 and close by Day 180.

One differentiator with a DST is that each offering has a limited amount of equity available, so investors need to plan their exchange and purchase accordingly.

Step 4: Hold the DST Investment

Once you close, you will be invested in the DST. How long you hold depends on whether you invest in a traditional DST or a 721 DST.

During the hold period, the property collects rents, pays operating expenses and debt service, and then distributes the remaining income to investors, typically on a monthly basis.

Investors do not have a say in the day-to-day management of the property during this period. The investment is managed by the sponsor.

• Traditional DST: The typical hold period is five to seven years. At the end of that period, investors generally have the option to complete another 1031 exchange into a DST, complete a 1031 exchange into other real estate, or cash out.
• 721 DST: The typical hold period is approximately two years before the planned conversion.

Step 5: The DST Property Is Contributed Through Section 721

With a planned 721 conversion, typically after approximately two years, an associated REIT will acquire the real estate held within the DST. This structure is commonly referred to as an UPREIT, or Umbrella Partnership Real Estate Investment Trust.

At this point, the investor’s ownership changes.

Before the 721 conversion, the investor owns a beneficial interest in a specific DST and the real estate held within that DST. At conversion, the investor exchanges that ownership interest in the real estate for operating partnership units, or OP units, of the REIT.

The investor has moved from ownership tied to one specific DST into an interest connected to a broader real estate portfolio.

Step 6: Hold and Potential Liquidity

Typically, an investor will remain in the REIT structure for approximately one year before liquidity becomes available. After that period, the REIT may offer monthly or quarterly liquidity.

Taking cash out is generally a taxable event, so investors also have the option to remain invested in the REIT and continue receiving monthly cash flow.

If a client does not want or need liquidity, they can remain within the REIT indefinitely, receiving monthly income.

Upon passing, the beneficiaries receive a step-up in basis and can cash out according to the REIT’s redemption program.

New to DSTs and want the fundamentals in one place? Our DST Investor Guide covers fees, structure and what to look for before you invest.

What Happens After the 721 Conversion?

Before the conversion, the investor’s economic interest is tied primarily to the real estate owned by the DST. After the conversion, that ownership is generally represented by OP units in the REIT’s operating partnership.

Depending on the REIT and offering structure, the investor may eventually have the ability to convert those OP units into REIT shares or otherwise seek liquidity according to the program’s rules.

That does not mean the investment becomes immediately liquid.

This is particularly important with non-traded REITs, where redemption programs may include restrictions, limitations and caps. The REIT may also have discretion to modify or suspend its redemption program.

Investors should therefore understand the specific liquidity provisions of the REIT they are entering rather than assuming that a 721 conversion automatically creates liquidity.

Can You Complete Another 1031 Exchange After a 721?

This is one of the most important differences between a traditional DST and a 721 DST.

With a traditional DST, when the underlying property eventually sells, an investor may generally have the opportunity to complete another 1031 exchange if the transaction and investor otherwise meet the applicable requirements.

After a 721 transaction, however, the investor generally owns an operating partnership interest rather than a direct interest in qualifying replacement real estate. Partnership interests generally do not qualify for Section 1031 treatment.

After a 721 conversion, investors generally cannot complete another 1031 exchange. Think carefully about your long-term objective before choosing a 721 strategy.

If the goal is to continue exchanging from one property into another over time, a traditional DST may offer a different exit path.

If the investor is looking for a long-term transition away from individual real estate ownership and toward a professionally managed portfolio, a 721 structure may warrant consideration.

Neither structure is automatically better. They are designed to solve different problems.

Why Do Investors Consider 721 DSTs?

The investors I typically see exploring 721 DSTs are long-term real estate owners who are ready to simplify.

They may have owned apartments, retail centers, industrial buildings or rental properties for decades. The property may have appreciated substantially, making an outright taxable sale unattractive.

At the same time, many of these investors no longer want to deal with:

• Tenants
• Leasing
• Property management
• Capital improvements
• Financing
• Future property acquisitions

A 721 DST can create a potential progression from direct real estate ownership, into a 1031 exchange, into a DST, and ultimately into an UPREIT operating partnership.

For the right investor, that can represent a gradual transition from active real estate ownership to a more passive real estate investment.

Traditional DST vs. 721 DST

Both a traditional DST and a 721 DST can initially be used as replacement property in a 1031 exchange. Their long-term strategies, however, are different.

A traditional DST is generally expected to own its real estate for a period of time and eventually sell the property. At that point, investors receive their share of the proceeds and can evaluate whether to complete another 1031 exchange, pay the applicable taxes or pursue another strategy.

A 721 DST, on the other hand, is generally designed with the intention of eventually contributing the real estate to a REIT operating partnership.

That can potentially provide broader diversification and a different long-term ownership structure. But investors are also giving up some of the flexibility associated with remaining in the traditional 1031 exchange cycle.

What Should You Evaluate?

I believe investors should look beyond the phrase “721 DST.” The structure is important, but so are the investments behind it.

Investors should evaluate the real estate they are initially purchasing, the sponsor managing the DST and the REIT they may eventually enter. Here are some of the questions I would evaluate:

The DST and the future REIT should both be evaluated. A DST is still real estate, and a strong future exit strategy does not make up for purchasing weak real estate today.

Is a 721 DST Right for Every Investor?

No.

A 721 DST can be useful for investors who want to move away from active property ownership and who are comfortable with the long-term implications of eventually owning an operating partnership interest associated with a REIT.

However, it may not be appropriate for investors who want to maintain maximum flexibility to complete future 1031 exchanges, or who may need significant near-term liquidity.

Before making a decision, investors should understand both phases of the transaction:

1. Is the DST itself a sound real estate investment?
2. Do the future REIT and 721 structure align with the investor’s long-term goals?

Those are two separate decisions, and both deserve careful due diligence. For more on how I weigh these options, see How I Evaluate 1031 Replacement Property Options.

Planning Next Steps

For many long-term real estate investors, a 721 DST can provide a thoughtful way to transition from active property ownership into a more passive real estate strategy while continuing to defer taxes and maintain exposure to real estate.

The key is understanding the full path: from the initial 1031 exchange, through the DST investment, and ultimately into the REIT structure.

When evaluated carefully, a 721 DST can be an effective planning tool for investors who are looking to simplify ownership, reduce management responsibilities and create a more streamlined long-term real estate strategy.