Before a 721 Conversion: Eight Questions About the One Way Door

For some investors, the appeal of a 721 exchange is simple. After decades of buying, managing and exchanging property, they want to stop making real estate decisions entirely, while still deferring tax and keeping exposure to property.

A 721 exchange, usually called an UPREIT transaction, offers that. Real estate is contributed to a real estate investment trust's operating partnership in exchange for partnership units, without immediate tax. The investor ends up with an interest in a large, diversified portfolio instead of individual properties.

What makes it different from almost everything else in this area is that it generally cannot be reversed. Before converting, these are the questions worth answering.

1. Are you certain you are finished with direct real estate?

Operating partnership units are not real property. They cannot be exchanged under Section 1031. Once your investment is in units, the path of repeated tax deferred exchanges generally ends.

If there is a realistic chance you will want to buy a building again, move into a property, or give a specific property to a child, converting may close off options you will want later.

2. How will you eventually get out?

Units can usually be converted into REIT shares or redeemed for cash, subject to the partnership's rules. Either step is typically a taxable event. The deferred gain from your entire exchange chain can become taxable at that point.

For many investors the realistic exit is not selling at all, but holding units until death so that heirs may receive a stepped up basis. If that is your plan, a 721 can fit well. If you expect to need the capital during your life, model the tax on redemption first.

3. Who controls the timing?

In many DST programmes designed for 721 transactions, the sponsor or the REIT holds an option to acquire the trust's property in exchange for units. You may not choose whether or when the conversion happens.

Read the offering documents for any fair market value purchase option or similar provision, and understand what happens if you would prefer to exchange out of the DST instead.

4. How liquid will the units really be?

Liquidity depends heavily on the REIT. Units in a partnership associated with a listed REIT may be convertible into shares that trade publicly. Units in a partnership associated with a non traded REIT may rely on redemption programmes with limits, suspensions and discounts.

Ask for the redemption history, limits and any periods in which redemptions were restricted.

5. What does the tax picture look like while you hold units?

Unitholders generally receive distributions and an allocation of partnership income, deductions and depreciation. Your share of partnership debt affects your tax basis.

Events inside the partnership, such as the sale of the property you contributed, or reductions in partnership debt allocated to you, can sometimes trigger tax even though you did nothing. Some agreements include tax protection provisions. Ask whether yours does and for how long.

6. How are fees and costs structured?

REITs carry management fees and other costs, and non traded structures in particular can have substantial layers of fees. Compare the total cost of owning units with the costs of your current property and with other passive options such as direct net lease or DST ownership.

7. How will your heirs receive and divide the units?

Units are generally easier to divide than a building, and heirs may receive a step up in basis. Check how transfers at death are handled, whether heirs can redeem, and any restrictions on transfer. Coordinate the estate plan with the partnership rules.

8. What does the REIT actually own?

You are exchanging concentrated exposure to your property for diversified exposure to someone else's portfolio. Understand the asset types, locations, leverage, tenant quality and track record of the REIT. Diversification is only valuable if the portfolio is one you would choose to own.

How does a 721 differ from a direct contribution?

Some owners contribute property directly to an operating partnership without first going through a DST. That can work for large properties a REIT specifically wants, but most individual investors do not own assets a REIT will accept directly.

The DST route is more common for individual investors. The investor exchanges into a DST interest under Section 1031, and after a holding period the DST's property is contributed to the operating partnership under Section 721. The two step structure is why investors should read the DST offering documents with the eventual 721 in mind, rather than treating the conversion as a separate decision for later.

Who is a 721 exchange right for?

Typically, investors who:

• ›Are confident they will never want to exchange into direct real estate again
• ›Want professional management and broad diversification
• ›Intend to hold until death so heirs may benefit from a step up
• ›Accept that the timing of conversion and redemption may be outside their control

It is less suitable for investors who value flexibility, expect to need their capital, or want to keep the ability to exchange repeatedly.

What to do first

Before investing in a DST that may later convert, read the offering documents for purchase option provisions and ask directly how the 721 process works. Then ask your CPA to model three scenarios: holding units until death, redeeming units during life, and remaining in direct real estate. The right answer often becomes clear only when the tax on the exit is visible.

Nothing here is tax, legal or investment advice. REIT and DST interests are securities offered through licensed broker dealers and definitive offering documents, and investing involves risk including loss of principal. Confirm your plan with your advisers before acting.