DST Real Estate and IRS Code 721

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    A significant development in recent years involves DST real estate utilizing Internal Revenue Code 721 to transfer DST interests into an UPREIT (Umbrella Partnership Real Estate Investment Trust). This process, known as a 721 exchange, allows investors to exchange investment properties for Operating Partnership (OP) units in an UPREIT. These OP units represent separate interests in a sponsor’s REIT.

    The 721 Exchange Process with DST Real Estate

    While, in theory, an investor can directly exchange a property into an UPREIT, in practice, REITs typically seek institutional-grade assets, which may not align with individual properties.

    REITs generally deal with properties valued between $50 million and $200 million. Therefore, the more practical approach involves a two-step process: completing a 1031 exchange DST and subsequently a 721 exchange.

    To begin, investors select a DST with a 721 UPREIT component. Not all DST real estate for sale are designed for eventual transfer into a REIT. The investor first completes a 1031 exchange DST with the intention of later executing a 721 exchange into an UPREIT. This usually requires a holding period of at least two years before the property can be transferred.

    Benefits of a 721 Exchange

    Once ownership is transferred to an UPREIT, investors benefit from the diversification of a larger REIT portfolio, similar to owning a diversified stock portfolio instead of a single stock. Here are some key benefits:

    1. Diversification: Investors gain exposure to a broad range of DST real estate assets within the REIT portfolio.
    2. Step-Up in Tax Basis: OP units in an UPREIT are eligible for a step-up in tax basis upon the investor’s death, potentially eliminating capital gains taxes under current law.
    3. No More Sequential 1031 Exchanges: Investors can remain in the UPREIT indefinitely, avoiding the need for continuous 1031 exchanges into DST properties.
    4. Liquidity: UPREITs typically offer greater liquidity, allowing for the liquidation of all or part of one’s investment on a quarterly basis, subject to availability.

    Disadvantages of a 721 Exchange

    While there are notable advantages, there are also three primary disadvantages to consider:

    1. No 1031 Exchange Option: Once in the UPREIT, investors lose the ability to execute further 1031 exchanges, potentially triggering taxable events upon exiting the UPREIT.
    2. Sponsor Control: The DST sponsor can compel investors to contribute their fractional ownership interests to the UPREIT. Some sponsors allow investors to opt for a 1031 exchange out, while others may only guarantee a partial right or require all interests to be transferred.
    3. Cash Flow Distribution: Annual cash flow distributions in an UPREIT are based on the number of OP units received at transfer. Even if the value of OP units appreciates, the cash flow remains tied to the initial number of units. For example, if you received 10,000 OP units at $50 each, and 10 years later they are worth $100 each, your cash flow will not double, but the value of your units will.

    Conclusion

    Investing in DST real estate and utilizing the 721 exchange process offers a strategic pathway for diversification, tax benefits, and potential liquidity. However, it is essential to weigh the benefits against the disadvantages, such as the loss of 1031 exchange flexibility and dependence on the DST sponsor’s decisions.

    For those considering DST real estate, understanding the intricacies of DST real estate and IRS Code 721 is crucial. Evaluating the potential benefits and risks will help investors make informed decisions about incorporating DST properties into their investment strategy. As always, consulting with a financial advisor or tax professional is recommended to tailor the investment approach to your specific needs and goals.

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