DST to 721 Exchange: Convert Your Delaware Statutory Trust Into a UPREIT Without Capital Gains
DST to 721 Exchange: Convert Your Delaware Statutory Trust Into a UPREIT Without Paying Capital Gains DST to 721 Exchange: Convert Your Delaware Statutory Trust Into a UPREIT Without Paying Capital...
DST to 721 Exchange: Convert Your Delaware Statutory Trust Into a UPREIT Without Paying Capital Gains
TL;DR: A Section 721 exchange lets Delaware Statutory Trust investors contribute their DST interest into a REIT's operating partnership in exchange for OP units — with no immediate capital gains tax. The deferred gain stays embedded in your OP unit basis until you convert to REIT shares or the partnership sells assets. If you die holding OP units, your heirs receive a stepped-up basis and the deferred gain disappears entirely. The one cost: you permanently surrender 1031 exchange flexibility. See the IRS statutory text at IRS.gov — Section 721 Overview.
Most DST investors know one exit: sell the DST interest, roll the proceeds into another DST through a 1031 exchange, and repeat until death. That works. But it locks you into illiquid, single-asset structures indefinitely. Section 721(a) of the Internal Revenue Code offers a second path. It allows a property owner — including a DST interest holder — to contribute that interest to a partnership in exchange for a partnership interest without recognizing gain or loss at the time of contribution. When that partnership is a REIT's operating partnership, the structure is called a UPREIT, or Umbrella Partnership REIT. The DST-to-721 exchange is how sophisticated real estate investors move from a fixed DST position into a UPREIT's operating partnership, preserving deferred gains while gaining access to diversification, potential liquidity, and a powerful estate planning outcome.
How the DST-to-UPREIT Conversion Works
The mechanical steps are straightforward, though the legal and structuring work behind each one is not.
Step 1: The DST interest qualifies. Not every DST can feed into a 721 exchange. The DST sponsor or a UPREIT operator must first structure the DST so that the beneficial interest is convertible into a partnership interest. Many DSTs are specifically designed with a 721 exchange as the intended exit from the start. The offering documents will state this explicitly.
Step 2: The investor contributes the DST interest to the operating partnership. Rather than selling the DST interest on the secondary market — a transaction that would trigger capital gains recognition — the investor contributes it directly to the UPREIT's operating partnership (OP). Under Section 721(a), no gain or loss is recognized at this point. The contribution is tax-neutral on the day it happens.
Step 3: The investor receives OP units. In exchange for the contributed DST interest, the investor receives operating partnership units. These are not publicly traded shares. They are limited partnership interests in the entity that owns the REIT's underlying real estate. OP units typically carry the same economic rights as REIT shares — distributions, appreciation — but they are not liquid in the way that publicly traded REIT shares are.
Step 4: The investor holds OP units, converts, or holds until death. From this point, three paths exist. First, the investor can hold the OP units indefinitely and collect distributions. Second, after a lock-up period — typically one to two years — the investor can convert OP units into REIT shares on a one-for-one basis. That conversion is a taxable event: the full deferred gain recognizes at conversion. Third, the investor can hold the OP units until death, at which point heirs receive a stepped-up basis at fair market value and the embedded gain disappears.
The Tax Mechanics
The governing statute is 26 U.S.C. § 721. Section 721(a) states the general rule: no gain or loss is recognized to a partnership or to any of its partners when property is contributed to the partnership in exchange for a partnership interest. That is the foundation of the entire structure.
Section 721(c) adds complexity. It governs situations involving built-in gain property contributed to a partnership where a foreign person is a partner, and it also addresses tiered partnership structures. For domestic DST-to-721 exchanges involving only U.S. investors, Section 721(c) is less commonly the controlling concern, but practitioners with tiered entity structures must analyze it carefully.
Basis carries over under Sections 722 and 723. Under Section 722, the contributing partner's basis in the OP units equals their adjusted basis in the contributed property at the time of contribution. Under Section 723, the partnership takes a carryover basis in the contributed property. This is how the deferred gain stays preserved inside the OP unit structure rather than evaporating — it is simply embedded in a lower basis that will produce gain upon a future recognition event.
Two events trigger recognition. First, converting OP units into REIT shares. That exchange does not qualify under Section 721 because the investor is receiving corporate stock, not a partnership interest. The IRS treats it as a taxable disposition. Second, the operating partnership selling assets that were contributed with built-in gain. This is where tax protection agreements matter.
Tax protection agreements are contractual commitments from the REIT operator to the contributing investor. The operator agrees not to sell the contributed assets during a specified protection period — often seven to ten years — or, if they do sell, to indemnify the investor for the tax liability triggered. These agreements are standard in well-structured UPREIT programs. Before signing any 721 contribution agreement, investors should confirm the presence, duration, and enforceability of the tax protection agreement in writing.
The Estate Planning Angle Most Investors Miss
This is the most compelling reason for older investors to consider a 721 exchange, and it is systematically underexplained by advisors focused on current-year tax planning.
Under Internal Revenue Code Section 1014, heirs who inherit property receive a basis equal to the fair market value of the property on the date of death. This is the step-up in basis rule. When an investor dies holding OP units with $800,000 of embedded deferred capital gain, those OP units pass to heirs at their fair market value on the date of death. The $800,000 of embedded gain is erased. The heirs can convert those OP units to REIT shares immediately after inheriting them and pay zero capital gains tax on the gain their parent deferred for decades.
This outcome is not available to an investor who holds a DST and keeps rolling it through 1031 exchanges. In that case, the heirs also get a step-up in basis, but they inherit the actual real property or DST interest directly. The step-up works in both structures. The difference is what happens between now and death. OP units inside a UPREIT may offer distributions, diversification across dozens of properties, and eventual liquidity that DST interests cannot match.
For investors over 65 with large embedded gains and no pressing liquidity need, holding OP units until death and letting the step-up erase the gain is a legitimate and legal tax elimination strategy — not merely deferral.
Which Operators Offer 721 Programs
Griffin Capital is among the most established operators in this space. Founded in 1995, Griffin Capital has managed approximately $23 billion in assets and has offered UPREIT structures designed to accept DST-to-721 contributions. Their offering documents detail the lock-up periods, conversion rights, tax protection agreement terms, and distribution policies applicable to OP unit holders.
American Realty Capital is another operator that has offered 721-compatible programs. As with any private REIT structure, the quality of the operator's underlying portfolio, their track record of distributions, and the transparency of their reporting are as important as the tax structure itself.
When reviewing offering documents for any 721 program, look for four specific items. First, a clear statement that the contribution qualifies under Section 721(a). Second, a tax protection agreement with a minimum protection period and a named indemnification obligation. Third, conversion rights specifying when and how OP units can be exchanged for REIT shares. Fourth, a redemption or liquidity mechanism in the event the investor needs cash before the REIT pursues a listing or liquidity event. Private REITs are illiquid. The promise of eventual liquidity is not a guarantee.
The Permanent Trade-Off You Must Understand
A 721 exchange is a one-way door. Once a DST interest is contributed to a UPREIT's operating partnership, the investor has converted real property into a partnership interest. That partnership interest is not real property. It cannot be exchanged tax-free under Section 1031 into another property. The investor has permanently exited the 1031 exchange market.
This matters because 1031 flexibility has real value. An investor who holds DST interests can sell them on the secondary market (at a discount, typically) or wait for the DST to liquidate, then roll the proceeds into another DST or direct real estate through a 1031 exchange. That ability to keep deferring and to keep repositioning into different property types — industrial, multifamily, net lease — disappears after a 721 contribution.
The upgrade makes sense in three specific situations. First, the investor has accumulated large deferred gains across multiple 1031 exchanges and wants to stop managing the complexity of repeated exchanges. Second, the investor is approaching estate planning age and wants to position the deferred gain for step-up elimination at death. Third, the investor genuinely wants the diversification and passive income characteristics of a UPREIT portfolio rather than exposure to a single DST asset.
It does not make sense for investors who are young, who want to preserve property selection flexibility, or who are uncertain about the quality of the specific UPREIT operator. The tax benefit of Section 721 does not overcome a poorly managed private REIT.
Frequently Asked Questions
Q: Can I do a partial 721 exchange — contribute part of my DST interest and keep the rest?
A: In some programs, yes. This depends on the DST structure and the UPREIT operator's acceptance policies. Partial contributions allow an investor to test the OP unit structure while retaining partial 1031 flexibility. Confirm this with both the DST sponsor and the UPREIT operator before assuming it is available.
Q: Do OP unit holders receive the same distributions as REIT shareholders?
A: Generally, yes. OP units are designed to be economically equivalent to REIT shares on a per-unit basis. Distributions flow through the operating partnership to OP unit holders at the same rate as dividends paid to REIT shareholders. The specific terms are defined in the limited partnership agreement and the contribution agreement.
Q: What happens if the REIT sells my contributed property during my tax protection period?
A: A properly drafted tax protection agreement requires the REIT to either avoid the sale or compensate you for the resulting tax liability. Some agreements require the REIT to offer a replacement property contribution or a tax gross-up payment. Review the agreement terms before contributing — not all tax protection agreements provide equal protection.
Q: Is there a minimum holding period for OP units before I can convert to REIT shares?
A: Yes. Most UPREIT programs impose a one- to two-year lock-up period before conversion is permitted. Some impose longer restrictions. The conversion right is typically described in a "redemption agreement" or "exchange rights agreement" attached to the contribution documents. Converting before the lock-up expires is generally not permitted and may trigger penalties under the partnership agreement.
Author Disclosure: Jeff Barnes, MBA has no personal position in any company, fund, or platform named in this article. Angel Investors Network has no current commercial relationship with any party mentioned. AIN provides marketing and education services, not investment advice. Past performance does not guarantee future results. All investments involve risk, including loss of principal.
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About the Author
Jeff Barnes, MBA
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