1. Why Investors Move From DSTs to UPREITs
A Delaware Statutory Trust (DST) is popular with 1031‐exchange investors who want passive ownership of institutional real estate while continuing to defer capital-gains and depreciation-recapture taxes. After a DST’s typical 5- to 10-year holding period, sponsors may offer investors a 721 “UPREIT” exit: the trust’s property is contributed to an umbrella-partnership REIT (UPREIT) and each DST owner receives operating-partnership (OP) units instead of cash. Because Section 721 treats the contribution as a non-recognition event, no immediate gain is realized—making the move attractive when a cash sale would otherwise trigger a large tax bill.
2. Mechanics of the DST-to-UPREIT Transaction
| Step | What Happens | Tax Result |
| Step 1 | DST sells or contributes its property to the REIT’s operating partnership. | DST itself recognizes no gain. |
| Step 2 | Each beneficial owner receives OP units sized to their fractional interest. | Investor’s adjusted basis and holding period carry over to the OP units. |
| Step 3 (Optional) | After a minimum holding period (often 12-24 months), OP units may be converted—one-for-one—into REIT shares. | Conversion is a taxable event; capital-gains and depreciation-recapture taxes become due |
3. Tax Consequences During Ownership
| Issue | DST | UPREIT (OP Units / REIT Shares) |
| Current income taxation | Net rental cash-flow passes through and is usually sheltered by depreciation deductions. | OP-unit distributions (and later REIT dividends) are taxed as ordinary income, qualified dividends, or return of capital. Little or no property-level depreciation flows through to individual unitholders. |
| Ongoing deferral | Depreciation lowers basis, but gain and recapture remain deferred until the DST sells or liquidates. Owner can roll again via another 1031. | Deferral lasts only until OP units are (a) redeemed for REIT shares or (b) sold for cash. No further 1031 exchanges are allowed once inside the UPREIT. |
| Capital-improvement depreciation | Continues each year at DST level. | Depreciation occurs at the REIT; investors receive it only indirectly via return-of-capital portions of dividends. |
| State tax leakage | Flow-through; investors may file in multiple states where properties sit. | Same state filing exposure while holding OP units, but converting to publicly traded REIT shares generally limits ongoing multistate filings to the REIT’s home state. |
4. Tax Consequences When You Exit
| Scenario | DST | UPREIT |
| Sponsor sells DST property and dissolves trust | Capital-gains and depreciation-recapture taxes due unless proceeds are reinvested via another 1031. | N/A |
| Investor sells DST interest on secondary market | Treated as sale of real property interest; gain and recapture recognized. | N/A |
| OP units are converted to REIT shares (usual UPREIT exit) | N/A | Entire deferred gain—including prior depreciation—recognized in the year of conversion, even if shares are retained. |
| REIT sells a contributed property | N/A | The REIT may distribute taxable capital-gain dividends. Investors cannot control timing. |
5. Estate-Planning Angle
Both structures deliver a step-up in basis at death. Heirs inherit either DST interests or OP units at fair-market value, erasing deferred capital gains and recapture. The UPREIT adds flexibility: heirs can convert stepped-up OP units into REIT shares and sell without tax.
6. Hidden Tax Traps in a 721 Exit
- Phantom-tax risk. If the REIT forces a conversion or sells assets during a market downturn, investors can owe tax on a gain that no longer exists in share value.
- Loss of future 1031 flexibility. Once in an UPREIT, you cannot re-enter the 1031 chain.
- Ordinary-income drag. REIT dividends often carry a higher ordinary-income component than DST cash-flow, reducing after-tax yield—though the 20 % §199A QBI deduction can soften the blow for certain non-traded REITs.
- Fee stack. REIT internal costs plus any advisor AUM fees continue indefinitely; some DST-to-UPREIT programs layer 1 % (or more) asset-management fees on top.
7. Putting It Together—Which Structure Is Tax-Efficient for You?
| Objective | Likely Better Fit |
| Maximize long-term deferral and keep 1031 “swap-till-you-drop” alive | Stay in DST / roll to new DST |
| Achieve liquidity without a direct sale, accept one-time tax hit later | 721 UPREIT exit |
| Maintain high depreciation shelter on cash-flow | DST |
| Simplify state filings, benefit from REIT share liquidity, eventual step-up for heirs | UPREIT |
8. Key Takeaways
- A 721 exchange is not a tax-free escape hatch—it simply postpones gain recognition until you convert OP units or the REIT triggers taxable events.
- Depreciation shelter differs dramatically. DST investors get direct Schedule E deductions; UPREIT holders generally do not.
- Future flexibility is lost once you trade into an UPREIT—you cannot re-enter the 1031 pipeline.
- Estate planning can favor either structure. Both offer a basis step-up, but REIT shares are easier to divide and liquidate.
- Evaluate fee drag and dividend character before committing to a 721 exit.
Because every investor’s situation is unique, always model the after-tax cash-flow, exit timing, and estate objectives before electing a DST-to-UPREIT pathway.
For more detailed projections or a second opinion on whether a 721 UPREIT exit aligns with your long-term tax strategy, reach out to Orvida Investment Advisors’ exchange advisory team.
