721 Exchange DSTs: 1031 Exchange into a REIT
Often called the "Grand Finale" of real estate investing, Section 721 allows you to contribute your property (or your Delaware Statutory Trust (DST) interests) into a Real Estate Investment Trust’s (REIT) Operating Partnership. In return, you receive OP Units—fractional equity in a massive, institutional-grade portfolio.
For most real estate investors, the journey begins with a "buy and hold" mentality. You hunt for deals, manage tenants, and fix the occasional midnight leak, all while using the IRC Section 1031 Exchange to "swap" your way into larger and larger assets. But eventually, a shift happens. The thrill of the "Three T’s"—Tenants, Toilets, and Trash—starts to fade, replaced by a desire for something that property ownership rarely provides: true freedom.
If you’ve spent decades building a portfolio, you’re likely sitting on a significant tax "time bomb." Selling outright means hand-delivering 20–30% of your hard-earned equity to the IRS in capital gains and depreciation recapture taxes. On the other hand, another 1031 exchange just resets the clock on another management-intensive property.
Enter the 721 Exchange, also known as the UPREIT.
Often called the "Grand Finale" of real estate investing, Section 721 allows you to contribute your property (or your Delaware Statutory Trust (DST) interests) into a Real Estate Investment Trust’s (REIT) Operating Partnership. In return, you receive OP Units—fractional equity in a massive, institutional-grade portfolio.
In 2026, the landscape has shifted. With interest rates stabilizing and the permanent restoration of 100% bonus depreciation, the stakes for high-net-worth investors have never been higher. This guide is designed to be the definitive resource for navigating this transition. Whether you are looking for passive income, institutional-level diversification, or the ultimate estate planning tool (the "Step-Up in Basis"), you’ll find the roadmap here.
Foundational Knowledge – The DNA of the 721 Exchange
If you’ve spent any time in the world of real estate, you know that the 1031 Exchange is the "holy grail" of tax deferral. But there comes a point for every seasoned investor, usually somewhere between their third multi-family renovation and their fiftieth "toilet-and-trash" emergency, where the desire for property is replaced by a desire for peace.
That is where IRC Section 721 enters the conversation. It is the sophisticated, liquid cousin of the 1031, and understanding how it works is the first step toward true passive wealth.
Understanding IRC Section 721: The Power of the Contribution
At its core, Internal Revenue Code Section 721 governs the "non-recognition of gain or loss on contribution" to a partnership.
In plain English? It means you can hand over your real estate to a partnership in exchange for an ownership interest in that partnership without triggering a massive tax bill from the IRS.
The Fundamental Shift: Property for Equity
The 1031 Exchange is a "swap" of one physical deed for another. Section 721 is a contribution. You aren't "selling" your building to a REIT (Real Estate Investment Trust); you are contributing your asset into their massive pool of properties. In return, you receive Operating Partnership (OP) Units.
The Mechanism of the Swap:
Valuation: Your property (or your fractional interest in a DST) is appraised at Fair Market Value.
The Contribution: You transfer the title/interest to the REIT’s Operating Partnership.
Equity Issuance: You are issued OP Units equal to the value of your contribution, minus any debt the REIT assumes on your behalf.
Jerry Baker’s Insight: Think of a 721 Exchange like merging a small stream into a massive river. Your individual 'stream' (your property) loses its specific banks and borders, but it becomes part of a much more powerful, steady flow of water. You still own a piece of the water; it’s just moving through a much larger channel now.
What is a UPREIT? (The Umbrella Partnership Model)
To understand how a 721 Exchange actually functions in the real world, you have to understand the UPREIT structure. "UPREIT" stands for Umbrella Partnership Real Estate Investment Trust.
In a standard REIT, the entity owns the properties directly. In a UPREIT, there is a middle layer called the Operating Partnership (OP). This is the "Umbrella."
The REIT (The Parent): Usually a publicly traded or large private entity that manages the portfolio.
The Operating Partnership (The Engine): This is where the actual real estate assets live.
The Investors: This is you. By contributing your property to the Operating Partnership, you become a "Limited Partner."
Why the "Umbrella" Matters
The UPREIT structure was specifically designed to solve a problem for wealthy property owners who were "asset rich but cash poor." They wanted to diversify but couldn't afford the 20-30% tax hit of a straight sale. By contributing to the OP under Section 721, the REIT gets your property to grow its portfolio, and you get a diversified security without the immediate tax drag.
OP Units vs. REIT Shares: The Twin Engines of Value
One of the most common points of confusion is the difference between the OP Units you receive and the REIT Shares you see quoted on a ticker or in an annual report.
While they are technically different legal instruments, for the investor, they are functionally "economic twins."
| Feature | OP Units (Section 721 Interest) | REIT Shares (Public Security) |
|---|---|---|
| Tax Status | Tax-deferred under IRC Section 721 | Taxable event upon conversion or sale |
| Distributions | Mirror REIT dividends (K-1 issued) | Standard dividends (1099-DIV issued) |
| Voting Rights | Limited to Partnership matters | Full Shareholder voting rights |
| Liquidity | Restricted (12-24 month lock-up) | High (Daily liquidity if public) |
Sources: IRC Section 721, IRS Publication 541, and Nareit UpREIT Guidelines.
The "Mirror" Effect
The value of your OP Units is typically pegged 1-to-1 with the value of the REIT’s common shares. If the REIT’s share price goes up 5%, your OP Units go up 5%. If the REIT pays a $0.50 dividend per share, you receive a $0.50 distribution per unit.
The Conversion Trigger
The most critical detail to remember: Converting OP Units into REIT Shares is a taxable event. The beauty of the 721 Exchange is that you can hold those OP Units indefinitely, continuing the tax deferral. You only "trigger" the tax when you decide you need the cash and convert your units into shares to sell them on the open market.
Jerry’s Insight
Don't ignore the 'Distribution' row in that table. Even though they are economically identical, the paperwork is different. With OP Units, you're a partner, which means you're waiting on a Schedule K-1. If you're the type of person who likes to file their taxes on February 1st, the 721 Exchange might test your patience, as K-1s often arrive later in the spring.
Jerry’s Insight
The magic of the OP Unit is its 'fractional liquidity.' In a 1031 Exchange, if you need $100k for a family emergency, you usually have to sell the whole building. With OP Units, you can convert just a small slice of your holdings into shares, sell those, and keep the rest of your fortune working for you in the tax-deferred 'river'.
The Two-Step Strategy (The 1031 to 721 "Bridge")
Most investors face a frustrating reality: Public REITs don't want your single-family rental or your local three-unit commercial building. They want institutional-grade assets worth $50M+. This creates a "gatekeeper" problem for the individual investor who wants to use Section 721.
The solution is a tactical maneuver known as the "Two-Step" or "Bridge" Strategy. This is how you take a smaller asset and "roll it up" into a massive institutional portfolio.
Step 1: The 1031 Exchange into a "721-Ready" DST
You can't jump straight from your property into the REIT’s Operating Partnership (OP). Instead, you use a Delaware Statutory Trust (DST) as a middleman.
The Sale: You sell your relinquished property using a Qualified Intermediary (QI).
The Identification: Within the standard 45-day window, you identify a DST that has a built-in "721 Exit Strategy."
The Closing: Within 180 days, you close on your fractional interest in that DST.
At this stage, you still own "real property" in the eyes of the IRS. You are still in the 1031 cycle, and your taxes are fully deferred.
Step 2: The 721 Conversion (The "Roll-Up")
This is where the magic happens. After a pre-determined holding period—usually 2 to 3 years—the REIT sponsor exercises an option to acquire the entire DST asset.
The Swap: Your DST beneficial interest is exchanged for OP Units in the REIT’s Operating Partnership.
The IRS Status: This swap is governed by Section 721. Because you are exchanging "interest for interest" within a partnership structure, it remains a non-recognition event.
The End of the Road: This is a one-way door. Once you accept those OP Units, you have officially exited the world of 1031 Exchanges. You now own a security (partnership interest), not real estate.
Why Not Just Go Direct?
Why do we go through the hassle of the DST? Why not just find a REIT and give them the property?
Asset Quality: As mentioned, REITs are picky. They want "Class A" industrial, medical office, or luxury multi-family. By buying into a DST, you are buying into an asset that already meets the REIT’s standards.
Diversification Bridge: A direct 721 exchange leaves you with a massive concentration in one REIT. The Two-Step allows you to 1031 into multiple different DSTs first, essentially building your own "mini-portfolio" before the final roll-up.
Tax Certainty: The DST structure is a well-trodden path with clear IRS rulings. Direct 721s for smaller properties are often complex, expensive, and legally "noisy."
Jerry’s Insight
Timing is everything here. The IRS has a 'Safe Harbor' guideline (Revenue Procedure 2004-86) that suggests you should hold that DST for at least 24 months before the 721 roll-up occurs. If the REIT buys the DST too quickly—say, after only 6 months—the IRS might argue that you never intended to hold the DST for investment, which could blow up your original 1031 deferral. Always check the 'Expected Hold Period' in the PPM (Private Placement Memorandum).
The Head-to-Head – 1031 Exchange vs. 721 Exchange (UPREIT)
At this point, you might be asking: "If the 721 is so great, why doesn't everyone do it immediately?" The answer lies in optionality. Choosing between a 1031 and a 721 isn't just a tax decision; it’s a lifestyle and legacy decision. A 1031 Exchange is about growth and active management, while a 721 Exchange is about preservation and passive income.
Think of it as the difference between owning the grocery store (1031) and owning stock in the parent company that owns 500 grocery stores (721).
Side-by-Side Comparison
To help you visualize the trade-offs, let’s look at the core mechanics. While both defer taxes, they behave very differently once the ink is dry.
| Feature | 1031 Exchange (Property/DST) | 721 Exchange (OP Units) |
|---|---|---|
| Asset Type | Fee Simple Real Estate or DST Interest | Partnership Equity (Securities) |
| Diversification | Concentrated (Specific Buildings) | Broad (Institutional Portfolio) |
| Exit Strategy | Can 1031 again into new property | The 1031 chain ends here |
| Liquidity | Low (Requires a full property sale) | High (Fractional conversion to shares) |
| Management | Active or Fractional (DST) | 100% Passive (Institutional) |
| Tax Reporting | IRS Form 8824 & Property Income | Schedule K-1 (Partnership) |
Sources: IRC Section 1031, IRC Section 721, and SEC REIT Guidelines (2026).
The "One-Way Door" Warning
This is the most critical takeaway of Part 3: The 721 Exchange is a one-way street. In a 1031 Exchange, you can "swap 'til you drop." You sell an apartment, buy a warehouse, sell the warehouse, buy a DST. As long as you keep buying "like-kind" real estate, the IRS stays at bay.
However, once you roll your interest into a 721 UPREIT, you no longer own "real estate" in the eyes of Section 1031. You own partnership units. You cannot 1031 out of OP Units into another building. Your only exit from that point forward is to hold the units, or convert them to shares and sell them (which triggers the tax).
Liquidity: The "Salami" Strategy
One of the biggest "pro" arguments for the 721 is what I call "Salami Liquidity." If you own a $2M apartment building and you need $100k for a medical bill or a grandchild’s tuition, you can’t just sell the roof or the parking lot. You have to sell the whole building, pay the tax on the whole gain, and find a new 1031 replacement.
In a 721 Exchange, your $2M is held in thousands of OP Units. If you need $100k:
You convert only $100k worth of OP Units into REIT shares.
You sell those shares on the open market.
You pay capital gains tax only on that $100k slice.
The remaining $1.9M continues to grow and pay dividends, fully tax-deferred.
Who is the 1031 better for?
The Accumulator: Investors still looking to maximize leverage and "trade up" into larger and larger assets.
The Hands-On Owner: Those who believe they can out-manage the market and want direct control over their tenants and cap rates.
Who is the 721 better for?
The Retiree: Someone who wants to turn off the "landlord brain" and receive a steady, diversified check.
The Estate Planner: High-net-worth individuals who want to hand a liquid, diversified portfolio to heirs who have no interest in managing a brick-and-mortar building.
Jerry’s Insight
I call the 721 the 'Hotel California' of real estate. You can check in any time you like, but you can never (tax-deferred) leave. Because you're trading a deed for a security, you’ve essentially retired from the 1031 game. Make sure you are 100% done with active management before you sign that 721 conversion paperwork.
Tax & Financial Implications – The Estate Planning "Gold"
If Section 721 is the "Hotel California" of real estate, then the Step-Up in Basis is the complimentary breakfast that makes you never want to leave. This section is where we move from "saving taxes today" to "eliminating taxes forever."
The Step-Up in Basis: Your Final Tax Act
The most powerful feature of the 721 Exchange isn't for you—it’s for your heirs.
When you die holding OP Units, those units receive a Step-Up in Basis to their current Fair Market Value. All of the capital gains you deferred from your original 1031 exchanges, and all the depreciation recapture you’ve been carrying for decades, simply evaporates. Your heirs can convert those units to cash immediately and pay essentially zero in federal capital gains taxes.
Jerry Baker’s Insight: I’ve seen families save millions using this. If you 1031 from a property you bought for $100k that's now worth $5M, you’re sitting on a $4.9M tax time bomb. If you sell, the IRS takes a huge bite. If you 721 into a REIT and hold until you pass, that 'time bomb' is safely dismantled by the Step-Up. It is the single most effective way to transfer wealth without the government taking a 20-30% cut.
Tax Reporting: Navigating the K-1
Transitioning to a 721 Exchange changes your relationship with the IRS. You are no longer reporting rental income and expenses on a Schedule E. Instead, you are a partner in a massive enterprise.
The Schedule K-1: Every year, the REIT will issue you a K-1. This form details your share of the partnership’s income, gains, losses, and credits.
Depreciation Shielding: Even though you don't own the "bricks and mortar" directly, the REIT’s massive depreciation expenses often flow through to you, frequently making a significant portion of your distributions "Return of Capital" (non-taxable in the current year).
Composite Filings: One of the best "quality of life" upgrades in a 721 is that most major REITs perform Composite Filings. This means they pay the state taxes on your behalf in the various states where they own property, so you don't have to file 15 different state tax returns.
Understanding the "Ticking" Tax Clock
It’s important to remember that tax is deferred, not exempted (until death).
Partial Liquidation: If you convert 10% of your units to shares and sell them, you trigger 10% of your deferred gain.
REIT Asset Sales: Occasionally, if the REIT sells a property that you specifically contributed, it could trigger a "built-in gain" (BIG) under Section 704(c). However, institutional REITs are masters at managing this to protect their OP Unit holders.
Jerry’s Insight
I’ve seen families save millions using this. If you 1031 from a property you bought for $100k that's now worth $5M, you’re sitting on a $4.9M tax time bomb. If you sell, the IRS takes a huge bite. If you 721 into a REIT and hold until you pass, that 'time bomb' is safely dismantled by the Step-Up. It is the single most effective way to transfer wealth without the government taking a 20-30% cut.
The Risks & Due Diligence – Looking Under the Hood
By now, the 721 Exchange probably sounds like a "no-brainer." But as an authoritative guide, we have to look at the "fine print." This isn't just about tax savings; it’s about moving from Real Estate Risk to Corporate & Market Risk.
The Hidden Risk Factors
Loss of Control: In a 1031, you (or your DST manager) make the calls. In a 721, the REIT’s Board of Directors makes the calls. If they decide to pivot from multi-family to office space right before a market shift, you're along for the ride.
The "Lock-Up" Period: Most UPREIT conversions come with a restriction period—usually 12 to 24 months—during which you cannot convert your OP Units into shares. You are effectively "illiquid" during this window.
Valuation Volatility: If the REIT is publicly traded, your net worth is now tied to the stock market. Interest rate hikes or REIT sector sell-offs can tank the value of your OP Units, even if the underlying buildings are doing fine.
Tax Law Changes: While the Step-Up in Basis is currently "Estate Planning Gold," it is frequently a target for legislative change.
Due Diligence: The Jerry Baker "Sniff Test"
Before you commit to a 721-Ready DST or an UPREIT, you need to vet the Sponsor. You aren't just buying a building; you're entering into a long-term partnership.
The Track Record: How many "Full Cycles" has this sponsor completed? You want to see that they have successfully moved investors from a DST into the Operating Partnership multiple times.
The Debt Structure: Look for "Non-Recourse" debt. You don't want the REIT's creditors coming after your personal assets if things go south.
Dividend Coverage: Is the REIT paying dividends out of its cash flow (FFO - Funds From Operations), or are they "cannibalizing" their own capital to pay investors?
Jerry’s Insight
Always ask for the 'Internalization' details. Some REITs are 'externally managed,' meaning they pay a separate company huge fees to run things. I prefer 'internally managed' REITs—where the management's interests are aligned with yours. If the managers are getting rich while the share price is flat, you’re in the wrong deal.