As seasoned 1031 Exchange Specialists, we often find ourselves discussing complex strategies with investors. One strategy gaining traction is using DST in 721 UPREIT transactions. You get the best of both worlds with this method: fewer dollars handed over to the taxman and more opportunities for your money to multiply over time. But what exactly is it, and is it the right strategy for you?
Table Of Contents:
- Decoding the Jargon: DSTs and 721 UPREITs
- Combining Forces: Using DSTs in 721 UPREITs
- Advantages of the 721 UPREIT
- Potential Considerations
- The Bottom Line: Seek Expertise
- Conclusion
Decoding the Jargon: DSTs and 721 UPREITs
First, let’s break down the terminology. A Delaware Statutory Trust (DST) is a legal entity used to hold real estate assets, allowing investors to purchase fractional ownership in larger, usually institutional quality real estate investments.
Investors in DSTs receive a proportionate share of the income and appreciation. A 721 UPREIT (Umbrella Partnership Real Estate Investment Trust) is a tax-deferred transaction structure.
Using Internal Revenue Code 721 , investors can exchange their DST interest for Operating Partnership Units (OPUs) in a REIT without triggering immediate capital gains tax. Essentially, they are swapping one form of real estate ownership for another. Smart financial planning means tossing taxi-saving tricks into your mix – like this gem that keeps tax problems on the back burner.
Combining Forces: Using DSTs in 721 UPREITs
Think of using DSTs in 721 UPREITs as a two-step process:
- 1031 Exchange into a DST: An investor uses proceeds from the sale of a relinquished property to purchase a DST interest. This initial step allows the investor to defer capital gains tax while benefiting from the DST’s cash flow and potential appreciation.
- Transition to a REIT: After a certain holding period (often two years or more), the sponsor may allow investors to roll their DST interest into the operating partnership of a REIT. This transaction, a 721 exchange, is also tax-deferred, enabling investors to consolidate their DST holdings into a potentially more diverse portfolio of properties.
Advantages of the 721 UPREIT
But why opt for this approach? From our experience working with investors over the past 23 years, the appeal lies in these advantages:
1. Capital Gains Deferral – Beyond the 1031 Exchange:
We always emphasize that 1031 Exchanges are powerful tools to defer capital gains tax. Using DSTs in 721 UPREIT structures extends this benefit further. Investors can avoid triggering a taxable event, giving them more control.
The capital gains tax from the sale of your initial relinquished property remains deferred until you eventually sell those OP Units.
2. Potential for Diversification:
We find that many investors initially own just one or two properties. DSTs already provide an entry point into fractional ownership of large-scale, institutional-quality real estate assets. Combining that with a 721 UPREIT adds another layer: exposure to a potentially even broader REIT portfolio encompassing a variety of property types and locations.
Here’s a comforting thought: a well-balanced portfolio that includes real estate can be your most trusted ally in turbulent times, providing a cushion against unexpected market dips. Just like no one advises investing all their money in one stock, we believe spreading risk across multiple assets and strategies is a prudent approach.
3. Estate Planning Benefits:
In our years guiding clients through 1031 Exchanges, we’ve noticed that many prioritize estate planning. Picture this: you’re calculating your financial gains, but don’t forget to account for capital gains taxes and depreciation recapture – they can make a huge difference. Upon the investor’s death, those OP Units can be passed onto heirs or beneficiaries.
Because the OPUs pass through a trust, beneficiaries often receive a “step-up basis” based on the current market value at the time of inheritance. This feature can result in those heirs avoiding the depreciation recapture and capital gains taxes their benefactor would have faced. With this exit strategy, the next generation won’t have to wrestle with the Challenges of asset transfer – it’ll be a much more manageable task. It can also create potential liquidity advantages if heirs choose to sell a portion of their inheritance, compared to selling a physical property.
Potential Considerations
While there are several advantages to using DST properties in 721 UPREIT transactions, we believe transparency is crucial. Getting the most out of this option requires investors to be proactive – they must thoroughly understand their role and the commitments that come with it. It’s essential to carefully evaluate any investment strategy and understand potential drawbacks:
1. No Further 1031 Exchange Options
Once your DST interest is converted into those OP Units within a REIT, those REIT shares, including your OP units, become ineligible for any future 1031 Exchange. Essentially, that final tax deferral stops there. It is crucial for investors to understand that opting for the 721 UPREIT path typically means eventually facing those capital gains liabilities. The real estate investor should look for DST sponsors who align with their investment strategies.
2. Potential Liquidity Challenges
Investors might experience challenges with accessing their capital. While the secondary market for real estate securities including DSTs has grown, they are still generally considered illiquid investments. Similarly, selling OP Units in a REIT often depends on the REIT’s structure, performance, and overall market conditions and demand.
Liquidity and the ease of selling shares can be influenced by a host of factors, including the overall performance of the REIT itself, prevailing market sentiment at any given time, as well as any specific terms dictated by the REIT or its sponsors. Investors should prioritize a thorough review of any sponsor’s buy-back policies and evaluate the frequency of those offerings to assess the potential ease (or difficulty) they might face should they desire a quick exit from their investment position. Investors should thoroughly consider their financial goals before investing.
The Bottom Line: Seek Expertise
Whether it is your first or your tenth 1031 Exchange, always remember that this strategy, just like any investment strategy, is not without its nuances. Successfully using DSTs in 721 UPREIT structures involves careful planning, thorough due diligence, and aligning your personal investment goals and risk tolerance.
Seeking guidance from your financial advisors, including your tax professional, remains crucial when venturing into this potentially advantageous – yet complex – arena. Getting ahead requires more than just making moves – it’s about making smart, informed decisions that are backed by a solid plan. By leveraging this strategy, you’ll gain instant access to a thriving new exchange, unlocking fresh possibilities in the world of real estate.
Conclusion
For those aiming for a combination of long-term capital appreciation, tax deferral, potential diversification beyond a typical 1031 Exchange, and an eye toward simplified estate planning, using DSTs in 721 UPREIT structures may align well with your goals. Hand in hand with pros who know the ropes, you’ll make informed choices that put your financial house in order. Think of strategic planning as the roadmap to success, and informed decisions as the vehicle that gets you there – together, they’re unstoppable.