What Every Investor Should Know About 721 Exchange UPREITs and DST Offerings

The increasing interest in 721 Exchange UPREITs (Umbrella Partnership Real Estate Investment Trusts) and Delaware Statutory Trust (DST) offerings reflects a shift in how investors approach real estate strategies. 

These methods offer unique tax benefits, diversification opportunities, and potential for steady income. However, they also carry complexity and risks that require thorough evaluation. Understanding these tools can help investors make informed decisions while minimizing potential pitfalls.

Understanding the 721 Exchange: A Strategic Tax-Deferral Mechanism

Section 721 of the Internal Revenue Code allows property owners to contribute real estate to a partnership in exchange for Operating Partnership (OP) Units without immediate tax consequences. This exchange provides a strategic path for deferring capital gains taxes, often serving as an exit strategy for investors in DSTs.

The typical 721 Exchange process involves three steps. The investor sells their property intending to execute a 1031 exchange. The sale proceeds are used to purchase an interest in a DST, which serves as an intermediary holding period. The DST interest is transferred to a REIT’s operating partnership, with the investor receiving OP Units in return. This sequence preserves tax deferral and positions investors to benefit from potential REIT income and appreciation.

Why Investors Are Considering 721 Exchange UPREIT Strategies

Recent trends in the real estate market, including demographics and increasingly onerous regulations, have made independent property ownership more demanding and, in some cases, less desirable. Many investors are selling real estate and transitioning into DSTs that offer a 721 Exchange exit. These strategies make sense for several reasons.

Investors benefit from multiple layers of tax deferral. Transitioning from real estate to a DST via a 1031 exchange and eventually into a REIT through a 721 Exchange postpones capital gains taxes. REIT structures may also, but not always, offer potential benefits as greater liquidity and tax-efficient income streams.

Owning a single property, say a single tenant NNN building or multifamily building, can over-concentrate risk (think of the expression ‘don’t put all your eggs in one basket’). DSTs and 721 vehicles often include portfolios spanning various markets and property types, reducing exposure to a single geographic region or even a single asset class. However, it is still important to remember that while diversification can lower risks, it does not eliminate them and does not guarantee profits or protection against losses.

Another potential benefit of the 721 UPREIT strategy is that by converting real property into Operating Partnership Units (OPUs), investors can capture potential income through regular distributions. In addition, by optimizing portfolios and acquiring new properties, REITs also have the potential to maintain or grow income streams and valuation over time, or in the case of some perpetual life and non-traded REITs, the potential to lose value and lower dividends to investors. 

The End of the Line for 1031 Exchanges

After the investor has deferred his/her taxes via the 1031 into a DST and via the 721 from the DST into the REIT, there are some often left out implications investors must be aware of.

For example, once an investor does the section 721 conversion into the REIT, he/she can NEVER do another 1031 exchange again with that equity. The second they sell their REIT shares, they are immediately taxable. So, all of the 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 now be due upon sale. Many investors, for this very reason, are opting not to invest in forced 721 UPREIT programs as they want the opportunity to continue with another 1031 exchange if they so desire.

Key Considerations Before Choosing a 721 Exchange UPREIT Program

While 721 Exchange UPREIT structures offer many advantages, investors must approach these opportunities cautiously. Various factors deserve scrutiny, as they can dramatically affect outcomes.

“Many of the 721 exchange UPREIT Delaware Statutory Trust (DST) investments available in today’s market to 1031 exchange investors, eventually will be called into a perpetual life non-listed real estate investment trust, which can trigger significant risks,” says Dwight Kay, Founder and CEO of Kay Properties and Investments. 

The Illusion of Stability: Borrowings and DRIP Programs

One of the most concerning practices in some perpetual life non-listed REITs is the use of borrowings and DRIP programs to fund dividend payments. At first glance, this might seem like a viable strategy to maintain high dividend yields, especially during periods of lower cash flow or when the REIT is in its early stages and yet to fully stabilize its property portfolio. However, this approach can create a dangerous illusion of financial stability.

Borrowings: A Debt Trap in Disguise

Using borrowings to pay dividends essentially means that the REIT is taking on additional debt to fulfill its dividend obligations. While this might help the REIT maintain its payout in the short term, it significantly increases the company’s leverage. High leverage can be a double-edged sword. On one hand, it can amplify returns during good times; on the other hand, it can lead to severe financial strain during downturns.

The danger here lies in the fact that as the REIT takes on more debt to pay dividends, it simultaneously increases its interest obligations. This can create a vicious cycle where the REIT might need to take on even more debt just to service existing debt and continue paying dividends. Over time, this can lead to unsustainable levels of debt, especially if the REIT’s property portfolio does not generate sufficient income to cover both the debt service and the dividends.

In economic downturns or periods of rising interest rates, the situation can quickly deteriorate. The cost of borrowing increases, due to the floating interest rate loans the 721 UPREIT perpetual life REIT sponsor utilized, reducing the cash flow available to cover dividends. In extreme cases, the REIT may be forced to cut dividends, sell assets at unfavorable prices, or even face bankruptcy.

DRIP Programs: Dilution and Dependency

Dividend Reinvestment Programs (DRIPs) allow investors to reinvest their dividends into additional shares of the REIT, often at a discounted price. While DRIPs are popular among investors seeking to potentially compound their returns, they can also become a crutch for REITs that are not generating enough cash flow from operations.

When a REIT relies heavily on DRIP programs to fund its dividends, it essentially issues new shares to pay dividends. This dilutes existing shareholders’ equity, as the REIT is increasing its share count without a corresponding increase in underlying assets or income. Over time, this can erode the value of each share, making the dividend yield appear artificially high.

Moreover, a heavy reliance on DRIPs can mask underlying cash flow issues. Instead of generating sufficient cash flow from property operations to cover dividends, the REIT is simply issuing more shares. This practice is unsustainable in the long run because it continually dilutes shareholder value and does not address the fundamental issue of insufficient cash flow.

The Unsustainability of Not Covering Dividends from AFFO

Adjusted Funds From Operations (AFFO) is a critical metric for assessing a REIT’s ability to generate cash flow from its core operations. Unlike Funds From Operations (FFO), which is a broader measure of operating income, AFFO adjusts for recurring capital expenditures and maintenance costs, providing a clearer picture of the REIT’s cash flow available for distribution.

When a REIT fails to cover its dividends with AFFO, it is a red flag that the dividends are not being generated from the REIT’s core property operations. Instead, the REIT may be relying on unsustainable practices such as borrowing or issuing new shares through DRIP programs to pay dividends to investors. This lack of coverage is a warning sign that the REIT’s dividends may not be sustainable in the long term.

Over time, if a REIT consistently pays dividends in excess of its AFFO, it depletes its capital reserves, erodes shareholder equity, and increases its financial risk. This practice can possibly lead to a downward spiral where the REIT is forced to cut dividends, sell assets, or take on even more debt, further exacerbating its financial instability.

Common Pitfalls and How to Avoid Them

With the rising popularity of 721 Exchange UPREIT strategies, the market has experienced a surge of new participants, leading to an overwhelming number of options for investors. This influx can make it difficult to determine which opportunity aligns best with an investor’s goals. However, focusing on a few critical factors can significantly enhance the decision-making process. 

Transparency of financial data is essential. Investors should demand clear and detailed reports, including offering documents and independent analyses, as ambiguity often conceals hidden risks. Equally important is the amount of debt the REIT has, how much of that debt is adjustable rate or floating rate debt, is the REIT is fully covering its dividend, or is a large portion of it is coming from borrowings and new investor equity, etc. 

When it comes to 721 UPREITs, being forced to participate is a common pitfall.  Investors must only consider 721 UPREIT DST investments, whereby full optionality is a feature—many Delaware Statutory Trusts (DSTs) provide the flexibility for investors to decide to participate in the 721 UPREIT or not.  This is always preferred as compared to being forced to participate in a 721 UPREIT.

As the real estate investment landscape continues to evolve, 721 Exchange UPREITs and DST offerings are poised to play an increasingly pivotal role in portfolio strategy and estate planning. Looking ahead, advancements in financial technology, regulatory shifts, and growing investor demand for passive income and tax efficiency are likely to refine and expand these structures. 

Sponsors and REIT managers will need to demonstrate greater transparency, innovation, and fiduciary discipline to meet the expectations of a more informed investor base. Meanwhile, investors who stay educated and proactive will be best positioned to leverage these tools not just for potential immediate gains, but for long-term wealth preservation and generational transfer potential.

About Kay Properties and www.kpi1031.com: 

Kay Properties helps investors choose 1031 exchange investments that help them focus on what they truly love in life, whether that be their children, grandkids, travel, hobbies, or other endeavors (NO MORE 3 T’s – Tenants, Toilets and Trash!). We have helped 1031 exchange investors for nearly two decades exchange into over 9,100 – 1031 exchange investments. Please visit www.kpi1031.com for access to our team’s experience, educational library, and our full 1031 exchange investment menu.

This material is not tax or legal advice. Please consult your CPA/attorney for guidance. Past performance does not guarantee or indicate the likelihood of future results. Diversification does not guarantee returns and does not protect against loss. Potential cash flow, potential returns, and potential appreciation are not guaranteed. There is a risk of loss of the entire investment principal. Please read the Private Placement Memorandum (PPM) for the offerings business plan and risk factors before investing. Securities offered through FNEX Capital LLC member FINRA, SIPC.