Many long-time real estate investors reach a point where they are tired of the “exchange treadmill,” the cycle of selling one property and immediately identifying and closing on another within tight deadlines, over and over, just to keep deferring tax. A 721 exchange UPREIT strategy offers a way off that treadmill: it lets an investor eventually convert real estate equity into units of a REIT’s operating partnership, and ultimately into REIT shares, while still deferring the tax that a direct sale would trigger. This guide explains how the “1031-into-721” strategy typically works, why investors use it, and the tradeoffs that come with giving up direct property ownership.
If ending the exchange cycle and moving toward more liquid, diversified real estate exposure is part of your long-term plan, talk with Aspen Exchange about how a 721 exchange might fit into your current 1031 transaction.
What Is an UPREIT and a 721 Exchange?
An UPREIT, short for Umbrella Partnership Real Estate Investment Trust, is a structure in which a publicly traded or non-traded REIT does not own its properties directly. Instead, the REIT owns a controlling interest in an operating partnership, and that operating partnership owns the underlying real estate. Under Internal Revenue Code Section 721, a property owner can generally contribute real estate to a partnership in exchange for units in that partnership without triggering immediate taxable gain, since a contribution to a partnership in exchange for a partnership interest is generally not treated as a taxable sale. When that partnership is a REIT’s operating partnership, this contribution is commonly referred to as a “721 exchange” or an “UPREIT transaction.” The investor receives OP units, which are generally structured so they can later be converted into REIT shares, or in some cases cash, typically at the investor’s election over time.
The “1031-into-721” Strategy
A direct contribution of real estate to an operating partnership under Section 721 is a separate transaction from a Section 1031 exchange, and the two are not interchangeable on their own. The strategy investors often use to link them together typically works in two stages:
- Complete a 1031 exchange into a DST. The investor sells relinquished real estate and, within the standard 45-day identification and 180-day completion windows, exchanges into a Delaware Statutory Trust interest that has been structured to hold real property meeting like-kind requirements. This step defers the original capital gain the same way any other 1031 exchange would.
- The DST later contributes its property into an UPREIT’s operating partnership under Section 721. At some point after the DST has held the property, often once the DST’s planned hold period is reached, the underlying property (or the DST itself) is contributed into the operating partnership of an affiliated REIT, and the DST’s investors receive OP units in exchange for their beneficial interests, generally without triggering the gain that had been deferred through the original 1031 exchange.
This is why the strategy is often described as “1031 into 721,” or sometimes informally as an “UPREIT exchange.” The investor never has to identify and close on another 1031 replacement property once they are in the DST; instead, the eventual move into OP units happens as part of the DST’s own planned exit strategy. For background on how DST interests fit into a standard exchange, see this 1031 exchange tax strategy guide.
Why Investors Use This Strategy
- Ending the exchange treadmill. Once an investor is holding OP units, they are no longer required to keep finding and closing on new replacement real estate every time they want to reposition. The REIT’s operating partnership continues to hold and manage the real estate.
- Further diversification. An UPREIT’s operating partnership typically owns a much larger and more diversified pool of properties than any single investor could hold directly, which can reduce concentration risk in a single asset, tenant, or market.
- A path toward eventual liquidity. OP units are generally structured to be convertible into REIT shares (and, if the REIT is publicly traded, those shares may offer meaningfully more liquidity than direct real estate ownership) or in some cases cash, typically at the investor’s election, subject to the specific terms of the operating partnership agreement.
- Continued tax deferral through the conversion into OP units. The 721 contribution itself is generally structured to avoid triggering the gain that has been deferred since the original 1031 exchange, continuing the deferral chain rather than resetting it.
- Estate planning flexibility. Some investors use this structure as part of a longer-term plan that also considers how OP units or REIT shares will be treated at death, though this should be discussed directly with an estate planning attorney.
The Tax Deferral Chain, Step by Step
It helps to think of this as a chain of deferral events rather than a single transaction:
- Step one: The investor sells relinquished real property and defers the gain through a standard 1031 exchange into a DST interest.
- Step two: At a later point chosen by the DST sponsor, generally as part of the DST’s planned disposition strategy, the DST’s real property (or the DST’s interest) is contributed to the UPREIT’s operating partnership under Section 721, generally without triggering the previously deferred gain.
- Step three: The investor now holds OP units rather than a direct or beneficial real estate interest. Gain generally remains deferred while the units are held.
- Step four: If and when the investor later converts OP units into REIT shares, or redeems units for cash, that event will generally be taxable at that time, so the deferral chain does not eliminate the gain, it postpones the tax event further down the line.
Because each step has its own conditions and timing, and because DST sponsors, not individual investors, generally control when the Section 721 contribution happens, this strategy requires trusting the sponsor’s long-term structure and disposition plans.
Tradeoffs to Understand Before You Commit
- Loss of direct real estate ownership. Once the property moves into the operating partnership, the investor holds a security (OP units, and eventually potentially REIT shares) rather than a direct interest in a specific piece of real estate. This generally also means the investor loses the ability to complete another 1031 exchange out of that specific property in the future, since it is no longer directly owned real estate.
- REIT-level risk. Once invested in OP units or REIT shares, the investor’s returns are tied to the performance of the REIT’s entire portfolio and management team, not just the single property they originally owned.
- Timing is generally not the investor’s choice. The decision to contribute DST property into the operating partnership is generally made by the sponsor, not the individual investor, so an investor entering a DST cannot necessarily count on a 721 contribution happening on a specific schedule.
- Eventual taxable event. Converting OP units to REIT shares or cash is generally a taxable event at that time, so this strategy defers tax further but does not make it disappear.
- Illiquidity during the DST and OP unit holding periods. Both DST interests and OP units are generally illiquid compared to publicly traded securities, and exiting early, if even possible, may be limited or costly.
Frequently Asked Questions
What does “721 exchange” mean?
It generally refers to contributing real property, or an interest in real property, to a partnership, such as a REIT’s operating partnership, in exchange for units in that partnership under Internal Revenue Code Section 721, generally without immediately triggering taxable gain.
How is a 721 exchange different from a 1031 exchange?
A 1031 exchange defers gain by exchanging one piece of real property for another. A 721 exchange defers gain differently, by contributing real property into a partnership in exchange for a partnership interest. The “1031-into-721” strategy links the two together, generally by first completing a 1031 exchange into a DST and later having the DST’s property contributed into an operating partnership under Section 721.
Do I lose my ability to do another 1031 exchange after a 721 contribution?
Generally, yes, for that specific property. Once the underlying real estate moves into an operating partnership, the investor is holding a partnership interest, not direct real property, and partnership interests generally do not qualify for further 1031 exchange treatment.
Is converting OP units to REIT shares a taxable event?
Generally, yes. Converting OP units into REIT shares, or redeeming units for cash, is typically a taxable event at that time, which is when the previously deferred gain is generally recognized.
Can I choose exactly when my DST property gets contributed into the operating partnership?
Generally not directly. That decision is generally controlled by the DST sponsor as part of the trust’s planned disposition strategy, so an investor entering a DST with a 721 exchange option should understand it as a possibility built into the structure rather than a date they control.
Why would an investor give up direct property ownership for REIT shares?
Common reasons include wanting broader diversification across many properties and markets, seeking a path toward greater eventual liquidity than direct real estate offers, and wanting to step off the cycle of repeatedly identifying and closing on new replacement properties within 1031 deadlines.
Plan Your Exchange and Long-Term Strategy Together
A 721 exchange is a longer-term strategic decision, not a routine step in a standard exchange, and it works best when it is part of a plan you understand from the outset rather than a surprise years later. Contact the Aspen Exchange team before you complete your next exchange to talk through whether a DST with a potential UPREIT option fits your long-term goals.
This article is educational information, not tax, legal, or investment advice. Consult your own qualified advisors regarding your transaction.