Editor's note: This is part two of a two-part series about forced Section 721 UPREIT conversions. Part one raised concerns related to some new Delaware statutory trust offerings that force investors into 721 UPREIT conversions at the end of the hold period.
In part one of this series, I discussed the risks associated with forced Delaware statutory trust 721 UPREIT conversions.
These types of conversions make investors exchange their DST interest for REIT operating partnership units, erasing the investor's option to choose whether or when to cash out or continue deferring taxes.
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Now I will discuss the flip side of these forced conversions and describe why the fully optional UPREIT conversions are far superior and what investors should know before investing in any 721 UPREIT exchange.
Benefits of traditional DSTs with full liquidation options
The traditional Delaware statutory trust investments, which don't involve an automatic UPREIT (umbrella partnership real estate investment trust), offer investors what many believe to be a more straightforward, investor-friendly exit path.
1. Full-sale liquidity and investor control
A classic DST has a defined business plan to sell the property outright after a holding period — typically about five to 10 years. When the DST goes full cycle and liquidates, investors receive cash proceeds from the sale of the real estate in proportion to their ownership.
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This provides a clear potential liquidity event — you get paid out in cash rather than being locked into a new vehicle. At that point, you control your own destiny, including deciding what to do with the proceeds.
You might choose to reinvest into another like-kind property via a 1031 exchange to continue deferring taxes — this could be another DST or a regular piece of real estate you'd purchase on your own, or take the cash (and pay the applicable capital gains tax) if that better suits your needs.
This flexibility means you aren't obligated to stay invested if market conditions or your goals have changed.
In a traditional DST, the investor has the freedom at exit to either cash out completely or roll into a new investment — whichever makes the most sense for them. By contrast, a forced UPREIT gives you no such choice at liquidity.
2. Tax-deferred exit via a 1031 exchange
If continuing tax deferral is a priority, a traditional DST naturally accommodates a 1031 exchange at exit.
Upon the DST's sale, you can execute another 1031 exchange into any other suitable replacement property (or another DST) on the market, preserving the uninterrupted tax deferral on your gains.
This benefit is the cornerstone of why many investors utilize DSTs in the first place — the DST structure qualifies as like-kind property under IRS rules, allowing a seamless 1031 exchange when the DST sells.
By rolling into a new property, you can keep deferring capital gains potentially indefinitely (or until you choose to cash out on your own terms).
Traditional DSTs keep the 1031 option open at each cycle, whereas a 721 UPREIT path forecloses it.
Additionally, with a traditional DST sale, you have the option not to exchange if, for example, you prefer to pay the tax and use the funds for other purposes, a valuable option that can be decided at the time of the sale.
In short, a standard DST offers maximum tax planning flexibility — you can evaluate the market and tax situation at the time of liquidation and decide whether to pursue another tax-deferred exchange.
3. Simplicity and alignment of interests
When a DST is designed to liquidate and distribute proceeds, the sponsor's interests are generally aligned with investors to maximize the sale value of the property and return profits.
The exit process is transparent — an open market sale of the real estate — with typically an independent buyer setting the price. There's no affiliated nontraded REIT transaction with complex and internally set pricing issues, as found in the forced 721 UPREIT DST investments.
For investors and committees, this straightforward outcome can be easier to underwrite and plan for. The DST ends, and investors walk away with any net cash proceeds and no strings attached.
This clear-cut result often suits investors who want control, clarity and the ability to reinvest on their own terms.
Optional 721 UPREIT DSTs can be the best of both worlds
Investing in a DST that offers a voluntary or optional 721 exchange at exit can be a best of both worlds strategy. In these structures, the DST sponsor has a REIT vehicle or portfolio available that is well-suited for a REIT, but each investor can choose at the time of the DST's disposition whether to exchange into the REIT or not.
Investor choice and flexibility. An optional UPREIT DST preserves investor control of exit timing and strategy. Rather than being automatically rolled into the REIT (a forced 721), you are given the option to participate in the 721 exchange.
You decide whether converting your DST interest into REIT units is advantageous for your situation.
This allows you to assess the REIT's performance, portfolio quality, debt exposure and terms — along with current market conditions — before deciding whether to invest.
If conditions are favorable — say the REIT is well-managed and in a financially healthy position in terms of their dividend coverage and debt levels — you might opt in.
If not, you simply decline the UPREIT and proceed with a normal cash sale (and 1031 exchange if desired) as you would in a traditional DST.
This optionality is crucial as it provides flexibility to align the exchange with market conditions and your financial goals. Essentially, you retain control: The 721 exchange becomes a voluntary tool rather than a forced mandate.
Timing benefit and downside protection. With an optional 721 structure, you're not locked into the REIT path if the timing isn't right. Real estate and financial markets are cyclical — by the end of a DST's hold period, interest rates, property values or the REIT's liquidity situation might differ significantly from the initial plan.
Having the choice to UPREIT or not provides a form of downside protection for individual investors.
For example, if the DST is ready to sell during a market downturn or if the REIT's redemption queues are backed up, you might prefer to take the sale proceeds and reinvest elsewhere rather than accept illiquid REIT units.
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Conversely, if the REIT is performing strongly and market conditions favor holding a diversified portfolio, the 721 option is available as a convenience.
In other words, an optional UPREIT lets you time your entry into the REIT structure wisely or avoid it entirely. This flexibility can potentially improve investor outcomes by preventing unwanted entanglement in a vehicle that doesn't fit your needs.
By retaining the 1031 exit as a fallback, you can compare the benefits of joining the REIT vs using your proceeds for other opportunities.
The mere presence of an investor option often incentivizes sponsors to ensure the REIT option is attractive (since they must earn your participation), which further protects investors from being shunted into a subpar investment.
Preservation of tax planning alternatives. In an optional 721 DST, if you choose not to contribute to the REIT, you still might receive the sale payout and can do a 1031 exchange into another property of your choice. This means the continuity of your tax deferral strategy remains under your control.
On the other hand, if you choose to UPREIT, it's because you've judged that the benefits (diversification, professional management, potential estate-planning advantages, etc.) outweigh the loss of immediate 1031 flexibility. The key is you decide based on your tax and investment objectives.
By having an optional UPREIT, you don't automatically forfeit the ability to structure your exchange or sale in a tax-efficient manner; you weigh that decision at the time of liquidity.
This is a far superior position to be in compared with a forced conversion, in which the path is set regardless of your personal tax situation or preferences.
Considerations and conclusion
When taking all the above into consideration, many of our investors — in the last nearly two decades — have decided it's clear that forced DST-to-UPREIT conversions potentially introduce significant risks — including loss of investor control, illiquidity and redemption uncertainty, opaque valuations and constrained tax planning.
Not only can these factors negatively impact an investor's ability to manage their portfolio, but they can also open the door to potentially significant tax liabilities. Investors would be wise to favor DST strategies that either maintain a traditional full liquidation or at least offer a voluntary 721 UPREIT option.
Traditional DSTs provide a clear and controlled exit (with the ability to take cash or do a new 1031 exchange), aligning with investors' need for liquidity and flexibility.
Meanwhile, optional UPREIT DSTs can offer the potential benefits of an UPREIT (diversification and continued deferral under Section 721) without sacrificing investor choice — you participate only if it makes sense for you.
By avoiding forced UPREIT provisions, investors preserve their autonomy and can make more optimal decisions at the time of sale or exchange.
We recommend conducting thorough due diligence on any DST's exit strategy before investing and leaning toward deal structures that prioritize investor optionality and transparency.
This approach will potentially help ensure that your 1031 exchange investment remains aligned with your financial objectives and that you're not unwittingly locked into and forced into a potentially unfavorable long-term vehicle.
It's important to clarify that forced 721 UPREIT DST programs are not inherently bad. Many are offered by well-established and reputable firms — some of which we've worked very closely with as a diversified piece for our large 1031 exchange clients.
However, investors must go in with eyes wide open and fully understand the structure and implications of a forced 721 UPREIT.
A critical step is thoroughly reviewing the final destination REIT's public SEC filings — specifically the 10-Qs (PDF) and 10-Ks (PDF) — to assess key factors such as dividend coverage, leverage ratios, debt maturities, exposure to floating rate debt and whether a tax protection agreement (TPA) (PDF) is offered, and for how long.
At Kay Properties, our dedicated due diligence team continuously monitors these metrics, which is one of the reasons why thousands of clients from across the United States over the years have relied on us to help guide them through 1031 exchanges into DSTs and 721 UPREIT investments.
Related Content
- How to Use DSTs and 1031 Exchanges for Diversification
- 721 UPREIT DSTs: Real Estate Investing Expert Explores the Hidden Risks
- Three Key Items to Evaluate When Choosing a 721 Exchange
- 721 Exchange to Defer Taxes: Pros and Cons
- Considering a 721 Exchange? Adopt a Buyer Beware Mindset
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