How to Invest in REITs

Many real estate investors know about 1031 exchanges.
Very few understand Section 721 — the tax code provision that lets investors move into a REIT structure without paying capital gains taxes.

Used correctly, a 721 can be one of the most powerful estate-planning and passive-income tools available.

Used blindly, it can trap your capital, eliminate your ability to 1031 again, and expose you to leverage and liquidity risks you never signed up for.

This is a clear, practical, investor-first guide to how you can move into a REIT structure.

What a Section 721 Exchange Really Is

A Section 721 exchange lets you contribute real estate to a partnership—typically the Operating Partnership (“OP”) that sits underneath a REIT—without triggering taxes on your gain.

“No gain or loss is recognized when property is contributed to a partnership in exchange for an interest in that partnership.”
—IRC §721(a)

In simple terms:

The REIT (or its operating partnership) wants your property
You contribute the property
You receive partnership/OP units instead of cash
No capital gains tax is triggered

But here’s the important nuance:

Most REITs do not acquire properties directly from individual owners.

How 721 Exchanges Work in the Real World

The most common path looks like this:

Step 1 — You Sell Your Property and 1031 Into a DST

You complete a standard 1031 exchange.
Your sale proceeds go into a Delaware Statutory Trust (DST) that the REIT has pre-selected.

All taxes are deferred under 1031
You receive fractional DST ownership
You begin receiving passive income

Step 2 — The REIT Rolls the DST Into Its Operating Partnership

After a holding period (typically 2–4 years):

The REIT absorbs (or “UPREITs”) the DST
Your DST interest is contributed to the OP
You receive OP units
Taxes remain deferred under 721

This creates a seamless, two-step tax-deferred transition:

1031 → DST → REIT (via 721)

It’s elegant.
It’s powerful.
And — if handled improperly — it can create risks many investors never see coming.

Why Some Investors Love 721 Exchanges

✔ Retire from landlord responsibilities

You never fix toilets, manage tenants, or deal with local regulations again.

✔ Diversification across many properties

Instead of owning one building, your OP units are backed by a portfolio of industrial, multifamily, retail, medical, and logistics properties.

✔ Access to structured liquidity

Non-traded REITs often offer redemption windows (subject to limits).

✔ Estate-planning benefits

If OP units are held until death, your heirs receive a step-up in basis — wiping out all past deferred gain.

✔ Exit California real estate without paying taxes

You can leave high-cost, low-yield markets without an immediate tax hit.

For many older investors (especially 65+), the 721 strategy is a clean, low-stress retirement exit.

The Hidden Risks No One Talks About

❌ 1. The REIT Is the End of the 1031 Road

Once your DST units convert into OP units:

You cannot 1031 again
Any future liquidation = taxable event

If long-term tax deferral matters, this is a major loss of optionality.

❌ 2. You Absorb the REIT’s Leverage—Whether You Want It or Not

Many investors 1031 into debt-free DSTs.

But the REIT they ultimately join may carry 50–70% leverage.

You inherit:

Adjustable-rate debt risk
Refinancing risk
Foreclosure risk
Interest-rate shock risk

This is the #1 surprise for conservative, low-LTV investors.

❌ 3. Debt Maturities Can Crush Distributions

Across the industry, many REITs have 30–50% of their debt maturing within 24 months.

Rising rates mean:

Higher interest expense
Lower AFFO
Reduced or eliminated distributions

This is happening in real time.

❌ 4. Redemptions Can Freeze Overnight

Structured liquidity ≠ guaranteed liquidity.

Non-traded REITs frequently:

Limit redemptions
Freeze redemptions
Adjust NAV downward during stressed periods

Investors need to be prepared for long holding periods.

❌ 5. Hidden Markups When REITs Sell Properties Into DSTs

Some REITs “drop down” properties they already own into DST wrappers at inflated prices to raise capital.

Example:

Fair market value: $100M
Dropped into DST at: $120M
Investors immediately start 20% underwater

This is one of the least-discussed risks in the industry.

❌ 6. Weak or Short-Term Tax Protection Agreements (TPAs)

If the REIT sells a property you rolled into:

Inside TPA window → you’re protected
Outside TPA window (often only 2–5 years) → you may owe taxes you did not expect

This is a real and material risk.

❌ 7. Forced UPREITs Eliminate Your Control

Some DSTs are structured as forced UPREITs:

No investor choice
No optionality
No ability to reassess market conditions
Timing dictated by the sponsor

For sophisticated investors, this can be a poor fit.

When a 721 Is a Great Fit

Ideal profiles:

Investors 65+ who want a final exit from management
Landlords ready to retire from active ownership
Investors who will never 1031 again
People who want diversified, passive exposure
Investors looking for estate-planning optimization
Those who may need liquidity in 3–7 years

If someone says:

“I never want to own or manage another property again.”

…a 721 can be the perfect solution.

When a 721 Is a Bad Fit

Poor fit for:

Investors under 60 building long-term wealth
Anyone who wants future 1031 optionality
Investors uncomfortable with leverage or refinancing risk
People needing predictable distributions
Clients who want control over timing and tax posture

This is why 721s should never be treated as the “default” recommendation.

Bottom Line

Section 721 UPREIT exchanges are powerful — but only when used thoughtfully.

They provide:

Passive income
Diversification
Potential liquidity
Estate-planning advantages
Full tax deferral

But they also carry:

Leverage risk
Liquidity risk
Loss of 1031 optionality
Hidden markups
TPA exposure
Redemption uncertainty

The right question isn’t:
“Is a 721 good or bad?”
It’s:
“Is a 721 right for this investor at this stage of their life?”

Used correctly, it’s an excellent tool.
Used casually, it can create preventable problems.

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