The 1031-to-721 Combo: Exchanging Into a DST, Then Rolling Into an UPREIT

The short version: You can defer gain on the sale of investment real estate by exchanging into a Delaware Statutory Trust (DST) under §1031, and then — once the DST's real estate is absorbed by a REIT's operating partnership — contribute your DST interest for operating-partnership (OP) units tax-free under §721. It's an elegant path from a single management-intensive property into a diversified, professionally managed, income-producing position. But it's a one-way door, and it deserves to be understood before you walk through it.

For years the most common question I hear at the end of a successful string of exchanges is some version of: "I'm tired of managing property, but I don't want to hand the IRS a third of my gain to get out. Is there a way to keep deferring and still be done being a landlord?"

There is. It's the two-step 1031-to-721 play, sometimes called the "DST-to-UPREIT" strategy. It combines two different nonrecognition provisions of the Code, and the combination does something neither section can do alone.

Why you can't just 1031 into a REIT

Start with what doesn't work. You cannot do a Section 1031 exchange directly into shares of a REIT. Replacement property in a like-kind exchange has to be real property, and REIT shares are securities, not real estate. So a direct swap of your rental into REIT stock is a fully taxable sale.

The two-step structure exists precisely to bridge that gap — real estate on the front end, a securities-like position on the back end, with tax deferral preserved across the seam.

Step one: The §1031 exchange into a DST

The first step is a conventional like-kind exchange, with a DST interest as your replacement property. Because it's a standard like-kind exchange, the usual mechanics apply: a qualified intermediary holds your sale proceeds, you identify replacement property within 45 days, and you close within 180 days — the same tax-deferred framework that governs any 1031 exchange.

The reason a DST interest qualifies at all comes from Revenue Ruling 2004-86. In that ruling the IRS held that a properly structured DST is treated as an investment trust — not a business entity or partnership — and that each beneficial owner is treated as owning an undivided fractional interest in the underlying real property. That "look-through" treatment is what makes the DST interest like-kind to the real estate you sold.

The catch is that the ruling's treatment only holds if the trust stays strictly passive. Practitioners refer to the restrictions as the "seven deadly sins" — the trustee generally cannot:

take in new capital after the offering closes;
refinance or renegotiate the existing debt, or borrow new money;
reinvest sale proceeds;
make more than minor, non-structural improvements to the property;
reserve cash beyond what's reasonably needed for operations;
renegotiate leases or sign new ones (usually solved with a master lease); or
otherwise act beyond passively holding and maintaining the asset.

Those constraints are not fine print — they are the whole reason your interest is treated as real property rather than a partnership interest. A DST that violates them risks being reclassified, which would blow the like-kind treatment.

There's also a practical benefit worth noting: because the DST's non-recourse debt is allocated proportionately to the beneficial owners, you can generally satisfy the debt-replacement requirement of your exchange without personally qualifying for or guaranteeing a new loan.

Step two: The §721 contribution into the UPREIT

Here's where the second provision comes in.

Most DSTs today are sponsored by, or affiliated with, a REIT. In the UPREIT ("umbrella partnership REIT") structure, the REIT doesn't own real estate directly — it owns a controlling interest in an operating partnership (the "OP"), and the OP owns the properties.

At some point in the DST's life cycle, the REIT's operating partnership acquires the DST's underlying real estate. When it does, you contribute your interest to the OP and receive OP units in exchange. That contribution is governed by §721(a), which provides that no gain or loss is recognized when property is contributed to a partnership in exchange for an interest in that partnership.

So the §721 step is tax-free on the way in. Your basis carries over to the OP units under §722, and the deferred gain rides along with them — tracked under §704(c) — rather than being triggered.

OP units are economically comparable to REIT shares: they generally receive the same distributions. But legally they are partnership interests, and that distinction drives everything that follows.

What you gain

For the right investor, the payoff is real:

You're out of active management. No tenants, no toilets, no 45- and 180-day clocks the next time you want to reposition.
Diversification. Instead of one building, you hold a slice of an entire institutional portfolio.
Continued deferral. The gain you've been rolling forward — potentially across decades of exchanges — stays deferred through both steps.
An estate-planning endgame. This is the part that matters most to a lot of my clients, and I'll come back to it below.

The honest tradeoffs

I'd rather you hear these from me now than discover them later.

It's a one-way door. This is the single most important thing to understand. Once you hold OP units, you hold a partnership interest — and since the 2017 Tax Cuts and Jobs Act limited §1031 to exchanges of real property only, a partnership interest no longer qualifies for like-kind treatment. (Before 2018 there was a specific carve-out for partnership interests at old §1031(a)(2)(D); the TCJA made even that unnecessary by dropping personal and intangible property from §1031 entirely, and the 2020 final regulations under Treas. Reg. §1.1031(a)-3 confirm a partnership interest isn't "real property.") The upshot is the same either way: you cannot later exchange OP units into a new piece of real estate on a tax-deferred basis. The serial-exchange flexibility you had as a direct owner ends the moment you complete the §721 step.

Deferral is not forgiveness — and some later moves are taxable. The gain isn't gone; it's parked in the OP units. Certain events pull it back out:

Converting OP units into REIT shares is a taxable event. OP units are typically convertible into publicly traded REIT stock, but that conversion is treated as a disposition of your partnership interest and triggers the deferred gain — including unrecaptured §1250 depreciation and any applicable net investment income tax.
A cash redemption of the units is taxable, for the same reason.
If the REIT is acquired or taken private, unit holders can be forced to cash out, which also triggers the gain.

Liquidity is limited. OP units aren't cash. They usually carry a hold period before redemption is available, and redemption programs can be capped, discretionary, or suspended in stressed markets. If near-term liquidity is your goal, this is the wrong structure.

You give up control. Between the DST's passivity rules and the OP's institutional management, you are a passive investor from the day step one closes. That's the point for some people and a dealbreaker for others.

Timing isn't fully in your hands. The §721 step happens when the REIT's OP decides to acquire the DST's assets — not necessarily when you'd choose. Some DSTs are "hardwired" toward a set conversion path; others are "hybrid" and give you a choice between a cash buyout (taxable) and the §721 roll-up. Know which one you're signing up for before you commit.

The estate-planning endgame

For clients whose real goal is to pass wealth to the next generation, the combination gets genuinely powerful.

If you hold the OP units until death, they're eligible for a step-up in basis to fair market value under §1014. Because the deferred gain was carried in the units' basis, the step-up can permanently eliminate the gain you've been deferring — potentially across an entire career of exchanges. Your heirs receive the units with a fresh basis, and the lurking §704(c) gain simply evaporates.

That's the "swap 'til you drop" strategy with a clean landing: exchange into the DST, roll into the OP units, hold, and let the step-up finish the job. The catch, of course, is that the strategy only pays off in full if you're genuinely comfortable never converting to shares or cashing out during your lifetime.

Is it right for you?

The 1031-to-721 combo tends to fit an investor who:

is ready to stop actively managing real estate for good;
values diversification and steady income over control;
doesn't need to pull the equity out anytime soon; and
is thinking seriously about what passes to heirs.

It tends not to fit someone who may want to get back into direct real estate later, who needs liquidity in the near term, or who isn't comfortable with a passive, illiquid position they can't easily undo.

If you've read our earlier piece on Delaware Statutory Trusts in a 1031 exchange, think of this strategy as the natural sequel: the DST gets you in, and §721 decides where the road ends.

As always, the structure has to be built correctly from the first step — the DST has to qualify, the exchange has to be done right, and the §721 mechanics have to line up. If you're weighing this for a property you're getting ready to sell, let's talk it through before you list it.

This article is for general educational purposes and reflects the law as of its publication date. Specific transactions depend on your own facts; Olympic Exchange Accommodators is happy to help you evaluate whether this structure fits your situation.

The 1031-to-721 Combo: Exchanging Into a DST, Then Rolling Into an UPREIT