One of the most important questions that real estate investors sometimes forget to ask themselves is, “What is my long-term, exit strategy?” This is especially the case for investors who are considering a Delaware Statutory Trust (DST) investment as part of their 1031 Exchange strategy. Most accredited investors understand the holding period for a Delaware Statutory Trust investment is around 5-7 years (although it could be shorter as I have seen offerings go sold within as fast as a year and half and personally, I have been an investor in a DST that was held for over 12 years). After that, the investment will typically go “Full-Cycle”, a term used to describe a DST property that is purchased on behalf of investors and then after a period of time is sold on behalf of investors. Once the investment goes full-cycle, investors need to evaluate what their next investment move should be including one of these common exit strategies:
- Cashing out and triggering a significant taxable event
- Enter into a subsequent 1031 Exchange into a Delaware Statutory Trust or other eligible like-kind property
- If available, effectuate a 721 Exchange into a DST Sponsor’s UPREIT offering
Option One: Cashing Out
Because of tax consequences, this is usually the least appealing option for many investors. However, there are times when investors may want to sell their real estate investments following the DST 1031 Investments and simply cash out, deciding to pay the associated tax liabilities that can quickly add up; Federal Capital Gains (15-20%), State Capital Gains (0-11.3% depending on the state he/she lives in), Depreciation Recapture Tax (25%) and the Medicare Surtax (3.8%) will all be due upon sale. This final tax bill for many investors may be very large, convincing many investors to seriously consider the next two exit strategies: the 1031 exchange or a 721 exchange.
Option Two: 1031 Exchange.
A 1031 exchange (also known as a like-kind exchange) is the most popular and therefore most familiar exit strategy for investors following a DST investment full-cycle event. Because section 1031 only defers the gain that would otherwise be recognized in a taxable sale, many real estate investors do not sell their replacement properties, they continue to exchange it, and continue the deferral by exchanging over and over. In this way, investors enter a series of exchanges, sometimes completed over decades. This is commonly known as a “swap ‘till you drop” strategy. This has proven to be an effective strategy for building real estate wealth over time and creating an estate planning tool.
Option Three: 721 Exchange Option
The third potential option for exiting a DST investment following a full-cycle event is called a 721 Exchange or “UPREIT”.
Section 721 of the Internal Revenue Code allows owners of real estate property to contribute, on a tax deferred basis, their physical property to a partnership, in exchange for interests in the partnership ( a 721 Transaction). Real Estate Investment Trusts (REITs) often hold real estate through an operating partnership known as an Umbrella Real Estate Investment Trust, or “UPREIT” structure. This structure allows holders of real estate to exchange real property for economic interest in the REIT in the form of operating partnership units by contributing that property to the partnership in a 721 Transaction. The operating partnership units have economic rights that are identical to the rights of the shares of the REIT, and after a designated holding period can be converted into shares of the REIT (in a taxable transaction) for liquidity purposes.
A Brief History of the 721 Exchange
The 721 Exchange was established in 1954 and has become an increasingly important strategy for real estate investors. REITs were able to incorporate 721 Exchanges as part of the Internal Revenue Code of 1986, and further amended in 2019. Most importantly, the 721 Exchange is considered established law, and are believed to have minimal chances for changes associated with political or tax law.
Interestingly, the 721 Exchange is one of the least known DST exit strategies by even experienced investors, but it does provide investors who have entered the DST structure as part of a 1031 Exchange another exit option following a DST full-cycle event. The main caveat to the Section 721 exchange is that once an investor proceeds with the exchange, they lose the ability to continue 1031 exchanging and deferring taxes.
Potential Tax Benefits and Estate Planning Options of a 721 Exchange Exit Strategy
Along with tax deferral, there are other potential benefits for investors who opt to participate in a 721 Exchange, including:
- Diversification opportunities offered by entering a larger REIT portfolio
- Eliminate the need to continually complete 1031 Exchanges
- Monthly tax efficient distributions and potential capital appreciation
- Increased liquidity and potential ability to liquidate a portion of one's investment over time
- Tax planning flexibility
- Estate planning possibilities due to the step-up in tax basis for heirs
- Divisibility of operating partnership units creating investment flexibility for heirs and partners
Which of these 1031 exchange alternatives is best for you? Every case is specific, so it’s best to consult a professional who can recommend the best 1031 exchange options based on the investor’s unique situation.
Kay Properties is a national Delaware Statutory Trust (DST) investment firm. The www.kpi1031.com platform provides access to the marketplace of DSTs from over 25 different sponsor companies, custom DSTs only available to Kay clients, independent advice on DST sponsor companies, full due diligence and vetting on each DST (typically 20-40 DSTs) and a DST secondary market. Kay Properties team members collectively have over 150 years of real estate experience, are licensed in all 50 states, and have participated in over $30 Billion of DST 1031 investments.
This material does not constitute an offer to sell nor a solicitation of an offer to buy any security. Such offers can be made only by the confidential Private Placement Memorandum (the “Memorandum”). Please read the entire Memorandum paying special attention to the risk section prior investing. IRC Section 1031, IRC Section 1033 and IRC Section 721 are complex tax codes therefore you should consult your tax or legal professional for details regarding your situation. There are material risks associated with investing in real estate securities including illiquidity, vacancies, general market conditions and competition, lack of operating history, interest rate risks, general risks of owning/operating commercial and multifamily properties, financing risks, potential adverse tax consequences, general economic risks, development risks and long hold periods. There is a risk of loss of the entire investment principal. Past performance is not a guarantee of future results. Potential cash flow, potential returns and potential appreciation are not guaranteed.
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