Capitalizing on Sections 1031 and 721 for REIT Investments
Navigating real estate tax strategies can feel overwhelming, but for investors, understanding Sections 1031 and 721 of the Internal Revenue Code can unlock powerful opportunities. Together, they create pathways to defer capital gains taxes, diversify portfolios, and increase liquidity — while still enjoying the benefits of real estate ownership. Let’s break it down.
Understanding 1031 Exchanges
A 1031 exchange allows investors to defer capital gains taxes when selling an investment property and reinvesting in “like-kind” real estate. This is one of the most powerful tools available to keep your capital working for you instead of going to the IRS. However, you cannot use a 1031 exchange to go directly into a Real Estate Investment Trust (REIT), because REIT shares are considered personal property, not real property.
The Role of Delaware Statutory Trusts (DSTs)
Enter the Delaware Statutory Trust (DST). A DST qualifies as real property under Section 1031, making it an eligible replacement investment. It allows multiple investors to pool capital and own fractional interests in high-quality institutional properties. For many, DSTs provide diversification, professional management, and a hands-off way to invest while still preserving 1031 tax benefits.
Transitioning to a REIT with a 721 Exchange
While you can’t 1031 directly into a REIT, you can use a two-step process. First, complete a 1031 exchange into a DST tied to an UPREIT (Umbrella Partnership REIT). Later, when the DST rolls into the UPREIT, you can convert your DST interest into Operating Partnership Units (OPUs) under Section 721. This is called a 721 exchange, and it allows you to defer taxes while ultimately gaining exposure to REIT shares.
Benefits of REIT Participation
Once inside a REIT, investors enjoy:
Liquidity: REIT shares can often be sold more easily than real property.
Diversification: Access to portfolios of office buildings, apartments, industrial centers, and more.
Passive Income: Regular dividends without the day-to-day responsibilities of property management.
Estate Planning Advantages: Simplified transfer of assets to heirs.
Potential Pitfalls to Watch
This strategy isn’t without drawbacks. REIT dividends are taxable as ordinary income, and once you convert to REIT shares, you lose eligibility for future 1031 exchanges. That means your flexibility to keep deferring taxes ends. Some REITs may also underperform compared to direct ownership or DST investments, making careful planning essential.
Putting It All Together
For investors seeking tax deferral, diversification, and liquidity, combining 1031 and 721 exchanges provides a powerful strategy. By starting with a DST and later transitioning into a REIT, you can keep your money working, reduce active management headaches, and position yourself for long-term growth.
Still, every investor’s situation is unique. Working with knowledgeable tax and legal advisors is critical to ensure the strategy is executed properly — and to decide whether staying in a DST or moving into a REIT is the best path for your goals.
Bottom line for investors: 1031 and 721 exchanges can work together to give you more options, more flexibility, and more opportunities to preserve wealth. But the right move depends on your needs for income, control, and long-term planning.
