1031 Exchange vs 721 Exchange: Deferral You Can Repeat vs a One-Way Door Into a REIT

Both defer the gain today; only one lets you defer again tomorrow

Section 1031(a)(1) defers gain when real property held for business or investment is exchanged for like-kind real property. The replacement is real property too, so when you sell it you can exchange again, and owners chain exchanges for decades.

Section 721(a) says "no gain or loss shall be recognized" when property is contributed to a partnership for an interest in it. In an UPREIT, that partnership is the REIT's operating partnership and the interest is operating partnership units, usually redeemable later for REIT shares or cash.

The difference is what you hold afterwards. The Form 8824 instructions list "interests in a partnership" and stock among property that does not qualify for like-kind treatment. Once you hold units, the exchange path is closed; after a 721, is it no more 1031 explains the narrow exceptions.

Most owners reach a 721 through a DST, on the sponsor's timetable

REIT operating partnerships accept direct contributions only of properties they want to own. The more common path is an exchange into a DST interest under Rev. Rul. 2004-86, followed by a later contribution to the sponsor's REIT. The DST-to-721 path covers that two-step route.

Filed documents show how the choice is presented. One non-traded REIT's Form 10-K for 2025 describes a fair market value option giving its operating partnership "the right, but not the obligation" to acquire DST interests for units, cash or both, with investors able to elect units or cash and at least 15% of the consideration available in cash when both are offered.

That makes the timing of your decision the sponsor's, not yours. Timing the 721 election covers how option windows are written into offering documents.

What you give up in a 721: control, future exchanges and tax-free exits

Exits from units are taxable. The same 10-K says unitholders can generally ask the operating partnership to redeem units "for, at our sole discretion, shares of our common stock, cash, or a combination of both." A sale or exchange of a partnership interest is taxed under section 741, and cash distributions beyond your basis in the units are gain under section 731(a).

The partnership rules add their own calendar. Section 704(c) allocates the built-in gain on contributed property back to you, and section 704(c)(1)(B) and section 737 trigger it if the property is distributed to another partner, or other property is distributed to you, within 7 years. Under Reg. section 1.707-3(c), a contribution followed by cash to you within two years is presumed a sale unless the facts clearly show otherwise.

Debt matters too. Section 752(b) treats any decrease in your share of partnership liabilities as a cash distribution, so a contribution that leaves you with less debt than you had can produce gain even with no cash in hand. Ask what share of debt will be allocated to you before electing.

What you gain in a 721: a portfolio, slices of liquidity and simpler estate administration

Units represent an interest in the whole operating partnership, so one building's vacancy matters less. Redemption in slices lets you sell a portion each year and spread the gain across tax years, which a single building or DST interest cannot do.

Liquidity has limits. The 10-K describes a share redemption program that may redeem fewer shares than requested, can be modified or suspended, and pays 95% of the transaction price on shares held less than one year. Units are not cash.

At death, units, shares and replacement real estate all receive a fair market value basis under section 1014, so heirs can sell without the deferred gain in either case.

Worked example: a $2,000,000 DST interest with a $500,000 basis at the option window

These figures are hypothetical. An investor holds a DST interest worth $2,000,000 with a $500,000 basis, and the sponsor exercises its purchase option.

• Elect units: no gain under section 721(a). If she later redeems $200,000 of units a year for cash, each redemption recognizes gain, roughly three-quarters of each payment if basis is recovered ratably, and the rest of her gain stays deferred until redeemed or until death.
• Elect cash and exchange: the sale for cash goes through a qualified intermediary and she buys $2,000,000 of new real property or DST interests within 180 days. No gain now, and the next sale can be exchanged again.
• Elect cash and keep it: the full $1,500,000 gain is taxed in that year at the depreciation and capital gain layers, plus the 3.8% surtax above the thresholds.
• Run your own numbers with your CPA; the right choice depends on age, income needs and whether heirs will inherit.

Which door to choose, and why many investors keep both open as long as possible

Stay with 1031 if you want to choose your own properties, may want to own real estate directly again, or plan to keep deferring until death. Interests in DSTs and direct title securities let you stay in real property without day-to-day management. With a direct title security the owner decides when to sell, refinance or move into a 721 exchange, rather than waiting on a sponsor's option.

Choose 721 if diversification and gradual liquidity matter more than future exchanges, and you understand that each redemption is a taxable sale. Ask for the operating partnership agreement, the redemption terms, any lockup and how debt will be allocated to you before electing.

The decision does not have to be made at the first exchange. A DST that offers a 721 option at the sponsor's discretion still lets you take cash and exchange again if the option allows a cash election.