Exit Strategies: Using 1031 DST or 721 DST exchange

Understanding the Differences Between a 1031 DST and a 721 DST Exchange

Savvy investors often look for strategies to defer taxes and maximize returns. Two such strategies are the 1031 exchange and the 721 exchange, both of which can involve Delaware Statutory Trusts (DSTs). While they share some similarities, they serve different purposes and have distinct processes. Let’s dive into the details to understand the differences between a 1031 DST exchange and a 721 DST exchange.

1031 DST Exchange: A Tax-Deferral Strategy for Property Investors

What is a 1031 Exchange?

A 1031 exchange, named after Section 1031 of the Internal Revenue Code, allows real estate investors to defer paying capital gains taxes on the sale of an investment property by reinvesting the proceeds into a like-kind property. This powerful tool helps investors continue to build wealth without the immediate tax burden that comes with selling appreciated property.

How Does a DST Fit In?

A Delaware Statutory Trust (DST) can act as the replacement property in a 1031 exchange. Here’s how it works:

1. Sale of Original Property: The investor sells their property and uses a Qualified Intermediary (QI) to hold the proceeds.

2. Identification Period: Within 45 days, the investor identifies potential replacement properties, which can and should include DSTs.

3. Acquisition: Within 180 days, the investor uses the proceeds held by the QI to acquire an interest in the DST, thereby deferring capital gains taxes.

Advantages of a 1031 DST Exchange:

- Diversification: DSTs typically hold multiple properties, allowing investors to diversify their portfolios.

- Management Relief: DSTs are professionally managed, relieving investors from day-to-day property management.

- Fractional Ownership: Investors can own a fraction of a larger, high-quality property that might be unaffordable individually.

721 DST Exchange: Converting Property into REIT Shares

What is a 721 Exchange?

A 721 exchange, named after Section 721 of the Internal Revenue Code, allows real estate investors to contribute their property to a Real Estate Investment Trust (REIT) in exchange for operating partnership units (OP units). This exchange is often referred to as an "UPREIT" transaction, which stands for Umbrella Partnership Real Estate Investment Trust.

How Does a DST Fit In?

In the context of a DST, a 721 exchange typically occurs as follows:

1. DST to REIT Conversion: Once a DST has aggregated enough properties, it may merge into an operating partnership of a REIT.

2. Exchange for OP Units: DST investors exchange their fractional DST interests for OP units in the REIT.

3. Liquidity Event: These OP units can eventually be converted into REIT shares, offering liquidity and potentially qualifying for dividends.

Advantages of a 721 DST Exchange:

- Liquidity: Investors can convert illiquid real estate holdings into liquid REIT shares.

- Diversification: REITs typically own a broad portfolio of properties, further diversifying an investor’s holdings.

- Tax Deferral: Similar to a 1031 exchange, a 721 exchange defers capital gains taxes until the REIT shares are sold.

Key Differences

Purpose: A 1031 exchange is primarily for deferring capital gains taxes when selling and reinvesting in new properties, while a 721 exchange is for converting property interests into REIT shares, offering liquidity and diversification.

Process: A 1031 exchange involves identifying and acquiring new like-kind properties or DST interests within a strict timeline, whereas a 721 exchange involves merging DST interests into a REIT’s operating partnership.

Outcome: The 1031 exchange results in continued property ownership (though possibly through a DST), whereas the 721 exchange results in ownership of REIT shares or OP units.

Which is Right for You?

The choice between a 1031 DST exchange and a 721 DST exchange depends on your investment goals. If your primary aim is to defer taxes and remain invested in real estate, a 1031 DST exchange might be more suitable. However, if you seek liquidity and diversified exposure to real estate with the added benefit of potential dividends, a 721 exchange could be the better route.

Both strategies offer powerful tools for real estate investors, providing avenues to defer taxes and optimize their investment portfolios. As always, it's crucial to consult with tax and financial advisors to determine the best strategy for your specific situation.

Disclaimer: The information provided in this blog post is for informational and educational purposes only and should not be construed as financial, legal or tax advice. While efforts are made to ensure accuracy, we do not guarantee the completeness or reliability of the information. Before making any financial decisions or changes, it is advisable to consult with a qualified professional who can assess your individual circumstances and provide tailored advice.