For investors who want to leave active real estate behind but aren't ready to give up all flexibility on day one, there is an elegant sequence that has become one of the most popular moves in tax-deferred real estate: 1031 into a Delaware Statutory Trust today, then 721 into a REIT later. Done well, the two-step lets you defer your capital gains tax now, keep your 1031 options open for years, and ultimately transition into a diversified, semi-liquid REIT position — all without triggering tax along the way. This memo explains how the two steps fit together, when the tax actually comes due, and where the strategy can disappoint.
- Step one is a 1031 exchange into a DST, which defers tax and keeps you in (fractional) real estate you could still exchange again.
- Step two is a 721 exchange at the DST's full-cycle, contributing the property to a REIT's operating partnership for OP units.
- The sequence defers tax through both steps; tax is triggered only later, when OP units are converted to shares or redeemed for cash.
- It's a one-way path — once in OP units you generally can't 1031 again — so the value is keeping flexibility until you deliberately give it up.
Why the two-step strategy exists
Each tool on its own has a gap the other fills. A 1031 exchange keeps you flexible but leaves you owning real estate — directly, or fractionally through a DST — that is illiquid and, in a single DST, fairly concentrated. A 721 exchange delivers diversification and eventual liquidity inside a REIT, but it's a one-way door you may not want to walk through prematurely. The two-step sequences them so the strengths line up: you get the 1031's flexibility now and the 721's diversification later, deferring tax the entire way.
The strategy is especially common among investors who are winding down active ownership over time rather than all at once — selling a building, parking the proceeds passively, and eventually consolidating into a REIT for simplicity and for an estate that's easier to divide. It is, in a sense, a glide path from active landlord to passive, diversified investor, with the tax bill deferred across the whole descent.
Step one: the 1031 into a DST
The first step is a conventional 1031 exchange into a DST. You sell your property, your qualified intermediary holds the proceeds, you identify within 45 days and close within 180, and you end up owning a fractional beneficial interest in a professionally managed, institutional-quality property. Because IRS Revenue Ruling 2004-86 treats a DST interest as direct real-estate ownership, this fully defers your capital gains tax and depreciation recapture, exactly as a direct-property 1031 would. Our memo on the 1031 into a DST covers this step in detail.
At this stage you've gained passivity and diversification (especially if you split across several DSTs) while keeping your 1031 optionality: if you changed your mind, you could exchange the DST interest into other real estate at its full-cycle. The two-step doesn't commit you to the REIT yet — it simply sets up the option.
Step two: the 721 into the REIT
The second step happens at the DST's full-cycle. Many DSTs today are deliberately structured to be "UPREIT-eligible," meaning the sponsor's affiliated REIT has the option to acquire the DST's property and offer investors a 721 exchange: instead of cashing out or doing another 1031, you contribute your interest into the REIT's operating partnership and receive OP units. The contribution is generally tax-free under Section 721, so the deferral you established in step one carries forward — now inside a diversified REIT rather than a single DST.
From that point you hold OP units that pay distributions tracking the REIT's dividends. After a holding period, those units can usually be converted into REIT shares or redeemed for cash — which is where, eventually, tax can come due. But the move from DST to REIT itself is designed to be a non-taxable continuation of your deferral.
The tax timing across both steps
The appeal of the two-step is that neither step triggers tax. The 1031 into the DST defers; the 721 into the REIT defers again. Your original gain — and the depreciation recapture — keeps rolling forward in your basis through both transactions.
Tax is generally triggered only at a later, separate event: when you convert your OP units into REIT shares, when you redeem them for cash, or, depending on the structure, if the REIT sells the contributed property in a way that passes through built-in gain. Each of those recognizes some or all of the deferred gain. And if you simply hold the OP units until death, your heirs may receive a stepped-up basis that can eliminate the deferred gain altogether — the same estate-planning endgame the 1031 offers, reached through the REIT. The practical point is to know which future action will trigger the bill, and to plan conversions deliberately rather than stumbling into a taxable redemption.
The benefits of the sequence
Stacked together, the two-step offers a distinctive combination. You get immediate tax deferral on the sale of your property; passivity from the moment you enter the DST; diversification that broadens from a single DST to an entire REIT portfolio; eventual liquidity through OP-unit conversion, which neither a directly owned building nor a single DST provides; and an estate-friendly end state, since OP units divide among heirs far more easily than a building and can be converted to shares as needed.
For the right investor, that's a remarkably complete package — flexible early, simple and diversified late, tax-deferred throughout. It's why UPREIT-eligible DSTs have become a mainstream destination for 1031 proceeds rather than a niche.
The trade-offs and risks
The strategy is not free of cost, and the honest version names the trade-offs. The most important is the one-way door: once you complete step two and hold OP units, you generally cannot 1031 back into real estate, so the flexibility you preserved in step one is now spent. There is also REIT dependence — your outcome shifts from a specific property to the performance and management of the whole REIT — and the reality that OP-unit "liquidity," especially in a non-traded REIT, runs through limited redemption programs and a taxable conversion, not a free public market.
Layered on top are the ordinary risks of each step: DST illiquidity and fees in step one, and the REIT's leverage, valuation, and distribution sustainability in step two. None of this argues against the two-step; it argues for entering it deliberately, with eyes open, and only when the eventual move into the REIT is something you actually want. We catalog the second-step risks in our memo on 721 exchange downsides.
Who the two-step fits
The two-step suits an investor who is transitioning out of active real estate over time, wants to defer tax now while keeping options open, and anticipates eventually valuing diversification and liquidity over control — often someone approaching or in retirement, or simplifying an estate. It fits poorly for an investor who wants to keep exchanging real estate indefinitely (for whom serial 1031s are better), or who may need full liquidity sooner than the DST and REIT timelines allow.
Because the sequence is deliberate and one-directional, the best users treat each step as a decision rather than a default: enter the DST knowing the REIT is the likely destination, and take the 721 only when you're genuinely ready to make the move permanent.
A worked example
Consider an illustrative investor nearing retirement who sells a long-held rental with a large gain. (Figures hypothetical.) In step one, she 1031s the proceeds into two DSTs — an apartment portfolio and an industrial offering — deferring all of her tax and immediately ending her landlord duties. She holds for several years, collecting distributions, while retaining the option to exchange again if she wished. When the apartment DST goes full-cycle, the sponsor's REIT offers a 721 exchange; ready now to consolidate, she contributes her interest for OP units, continuing her deferral inside a diversified REIT. She lives on the distributions, and because she intends to hold the units for life, she plans to pass them to her children with a stepped-up basis — potentially erasing the gain she's deferred since the original sale. The two steps did exactly what they're designed to do: flexibility first, permanence later, no tax in between.
Frequently Asked Questions
What is the two-step 1031-to-721 exchange?
It's a sequence: first a 1031 exchange into a DST to defer tax and stay flexible, then a 721 exchange at the DST's full-cycle to contribute the property into a REIT's operating partnership for OP units, continuing the deferral.
Does the two-step trigger any tax?
Neither step does — the 1031 and the 721 both defer. Tax is generally triggered later, when OP units are converted to REIT shares or redeemed for cash, or potentially when the REIT sells the contributed property.
Can I still 1031 after the 721 step?
Generally no. Once you hold OP units you can't 1031 back into real estate. That's why the two-step preserves your flexibility through step one and asks you to commit only at step two.
Why not just 721 directly?
Because a direct 721 commits you immediately and you'd usually need the right property the REIT wants. The DST step lets you defer now, stay passive and diversified, and keep 1031 optionality until you're ready to make the move permanent.
Who is the two-step best for?
Investors transitioning out of active real estate over time who want to defer tax now, stay flexible, and eventually value diversification and liquidity over control — often those approaching retirement or simplifying an estate.
Glossary
- UPREIT-Eligible DST
- A DST structured so the sponsor's REIT can acquire its property and offer investors a 721 exchange at full-cycle.
- 721 Exchange
- A tax-deferred contribution of property to a REIT's operating partnership for OP units.
- OP Units
- Operating-partnership units that pay distributions tracking REIT dividends and can later be converted to shares (taxably).
- Full-Cycle
- The point at which a DST's property is sold or contributed and the program concludes.
- Step-Up in Basis
- The reset of an asset's basis to fair market value at death, which can eliminate deferred gain for heirs.
Disclosures
This memo is published by Baker 1031 for general informational and educational purposes only. It is not investment, legal, or tax advice, and is not an offer to sell or a solicitation to buy any security. 721 exchanges, REITs, and DSTs involve substantial risk including illiquidity and possible loss of principal, and private offerings are sold only to verified accredited investors via private placement memorandum under Regulation D.
Every example here is illustrative and hypothetical, included to show how the mechanics work; it is not a projection or a representation about any specific transaction, and there is no assurance any return or tax treatment (including 1031 or 721 deferral) will be achieved. Tax results depend on your individual facts and on rules that can change. Securities offered through Aurora Securities, Inc., member FINRA / SIPC; Baker 1031 Investments is independent of Aurora Securities, Inc. Consult your own CPA and attorney before acting.
