1031 to DST and 721 Exchange: A Powerful Real Estate Tax Strategy for High Net Worth Investors
Written by Noah Schwab, CFP®, a Spokane financial advisor
If you own investment real estate with significant built-in capital gains, deciding how and when to sell can feel like a trap. You may want to reduce management headaches, diversify your exposure, or improve cash flow. However, selling outright can trigger a tax bill large enough to permanently erode your net worth.
For many real estate investors, particularly those with $500,000 or more in capital gains from property other than their primary residence, there is a sophisticated but often overlooked solution.
The 1031 to Delaware Statutory Trust to 721 exchange strategy.
This two-step approach allows investors to defer capital gains taxes, transition from active ownership to hands-off income-producing real estate, and eventually introduce diversification and liquidity through a REIT structure, all without triggering taxes at once.
As a Spokane financial advisor who works closely with real estate investors, retirees, and business owners, I will explain how this strategy works, who it is best suited for, the role of OP units, the tax advantages and trade-offs, and why structure and planning matter more than chasing returns.
Why real estate investors look beyond a traditional sale
Selling investment real estate outright often creates three major challenges.
1. Capital gains taxes
Federal capital gains taxes, depreciation recapture, and the net investment income tax can consume a significant portion of your gains, especially for long-held property with a low tax basis.
2. Forced reinvestment
Many investors feel pressured to rush into a replacement property simply to complete a 1031 exchange. This often leads to poor decisions, reduced diversification, or ownership of assets that no longer fit long-term goals.
3. Management fatigue
As investors approach retirement, the burden of tenants, maintenance, and operational decisions becomes less appealing, even when the property itself has performed well.
This is where the 1031 to DST and 721 exchange strategy becomes compelling.
Step one: using a 1031 exchange to move into a Delaware Statutory Trust
Section 1031 allows owners of real property held for investment or business use to defer capital gains taxes by reinvesting into like-kind real estate. When properly structured, a Delaware Statutory Trust qualifies as replacement property for a 1031 exchange.
A Delaware Statutory Trust allows multiple investors to own fractional interests in large institutional-quality real estate. From a tax standpoint, DSTs are commonly used because they meet IRS requirements for 1031 exchanges. From a practical standpoint, they offer fully passive ownership.
DSTs typically invest in assets such as multifamily apartments, industrial warehouses, medical office buildings, self-storage facilities, data centers, and necessity-based retail. These are properties that individual investors often cannot efficiently acquire or manage on their own.
Why do investors choose DSTs instead of other direct property
As a Spokane financial advisor working with landlords transitioning into retirement, the reasons clients choose DSTs are consistent.
Hands off ownership
Investors eliminate day-to-day management, leasing decisions, and operational responsibility.
Diversification
Proceeds can be spread across multiple DSTs, property types, tenants, and geographic regions rather than concentrated in a single replacement property.
1031 compliance
DSTs qualify as replacement property when structured correctly, allowing investors to defer capital gains taxes.
Income orientation
Most DSTs are designed to generate steady monthly or quarterly income, which is attractive for investors seeking retirement cash flow.
Example selling $15 million of farmland using a 1031 to DST
Consider a family that owns $15 million of highly appreciated farmland originally purchased for $50,000 decades ago. The family farmed the land for years and later began renting it to other farmers. The property now generates limited income and no longer aligns with their long-term goals. The husband is becoming less physically able to manage the land, and the wife is uncomfortable taking on that responsibility alone. The tax basis is extremely low.
An outright sale could trigger millions of dollars in federal capital gains taxes, dramatically reducing the amount they could reinvest.
Instead, the family completes a 1031 exchange and allocates the proceeds across several DSTs invested in multifamily, industrial, and medical real estate. The result is full deferral of capital gains taxes, diversified income-producing assets, and complete elimination of active land ownership responsibilities.
Example: selling a multifamily property with over $500,000 in capital gains
Now consider an investor who owns a small multifamily property valued at $900,000 and has more than $500,000 in capital gains. The property has been successful, but management has become burdensome, and the investor is nearing retirement.
Rather than reinvesting in another hands-on rental, the investor uses a 1031 exchange to move into DSTs. Capital gains taxes are deferred, income is treated as passive, and the investor gains exposure to higher-quality real estate without additional management.
At this stage, no taxes are triggered.
The hidden power of the strategy of the 721 exchange
Many investors view the DST as the endpoint. In reality, it is often the bridge.
The long term flexibility of this strategy comes from the potential ability to complete a 721 exchange.
Step two: the 721 exchange and the role of OP units
A 721 exchange allows investors to contribute real estate interests into a REIT’s operating partnership in exchange for operating partnership units, commonly referred to as OP units.
This distinction matters. Investors typically do not receive REIT shares immediately. Instead, they receive OP units in the operating partnership that owns the underlying real estate.
OP units represent ownership in the operating partnership and are designed to be economically similar to REIT shares. They usually receive the same distributions per unit as the REIT pays per share, and their value generally tracks the REIT share price.
However, OP units are not publicly traded shares. They are partnership interests and often come with different liquidity, transfer, and conversion rules.
From a tax perspective, this structure is powerful. Exchanging real estate or DST interests for OP units can qualify as a tax-deferred transaction under Section 721. No capital gains tax is triggered at the time of the exchange.
How OP units differ from REIT shares
OP units and REIT shares provide similar economic exposure but differ in structure.
OP units are partnership interests, while REIT shares are equity shares in the REIT itself. OP units are generally not freely tradable at issuance and may have holding period or conversion restrictions. REIT shares, particularly in publicly traded REITs, are typically liquid.
Most structures allow OP units to be converted into REIT shares or cash at a later date, often on a one-for-one basis. That conversion is usually when capital gains taxes are recognized.
This distinction is critical. The 721 exchange defers tax, but the eventual conversion or sale determines when tax is paid.
Why the 721 exchange introduces flexibility
By holding OP units, investors gain control over the timing of taxation. Instead of selling a property and triggering taxes all at once, they can convert OP units gradually, spreading taxable gains over multiple years.
OP units are also commonly used for estate planning. Under current law, if OP units are held until death, they may receive a step-up in cost basis. In many cases, heirs can then convert OP units into REIT shares with little or no capital gains tax.
Liquidity and diversification considerations
Liquidity depends on the REIT's structure. Publicly traded REITs offer market liquidity, while non-traded REITs may have limited redemption programs or longer holding periods.
Diversification often increases significantly at the REIT level, where investors may gain exposure to hundreds or thousands of properties across sectors and regions.
Risks and trade-offs to understand
No strategy is perfect, and a good Spokane financial advisor will clearly explain the trade-offs.
DSTs are illiquid during the holding period and must fit within an overall financial plan. Investors give up operational control. REIT values can fluctuate with interest rates and market conditions. The availability of a 721 exchange is sponsor-dependent and not guaranteed, which makes selecting the right DST and sponsor critical. Fees, income rates, and holding periods can vary widely between DST offerings.
Sponsor quality, balance sheet strength, and alignment of incentives matter significantly.
How This Strategy Fits Into Estate Planning
This strategy works best when coordinated with your estate plan. The goal is to balance liquidity with long-term tax efficiency.
By moving real estate into DSTs and then OP units through a 721 exchange, you can access some of the value for income or spending while preserving the remainder. The portion not sold may receive a step-up in cost basis at death under current law.
This allows you to generate income and access principal during your lifetime without giving up the full estate-planning benefits of the real estate, making coordination with your advisor and estate attorney essential.
How this fits into a financial plan
As a Spokane financial advisor, I do not view this as a standalone tax strategy. It must be integrated with retirement income planning, Roth conversion strategies, required minimum distribution planning, charitable giving strategies such as QCDs, estate planning, and overall portfolio diversification.
When done correctly, the result is tax-efficient income with flexibility and long-term planning advantages.
FAQ About 1031 to DST and 721 exchange strategy:
What is a 1031 to DST and 721 exchange strategy
A 1031 to DST and 721 exchange is a two-step real estate tax strategy that allows investors to defer capital gains taxes while transitioning from active real estate ownership to passive and diversified REIT ownership over time.
Who is this strategy best for
This strategy is best for real estate investors with significant capital gains, typically $500,000 or more, who want to reduce management responsibilities, defer taxes, and plan for retirement or estate planning.
What is a Delaware Statutory Trust
A Delaware Statutory Trust is a legal structure that allows multiple investors to own fractional interests in large institutional-quality real estate and is commonly used as replacement property in a 1031 exchange.
What is a 721 exchange
A 721 exchange is a tax-deferred transaction that allows investors to contribute real estate interests into a REIT operating partnership in exchange for operating partnership units, thereby avoiding capital gains taxes.
What are OP units
OP units are ownership interests in a REIT’s operating partnership. They are typically received in a 721 exchange and are economically similar to REIT shares but differ in structure and liquidity.
How are OP units different from REIT shares
OP units are partnership interests and are usually not publicly traded. REIT shares are equity shares and may be publicly traded and more liquid. OP units can often be converted into REIT shares at a later date, which is typically when taxes are recognized.
When do I pay taxes in this strategy
Taxes are generally deferred during both the 1031 and 721 exchanges and are usually recognized later when OP units are converted into REIT shares or sold for cash.
Is a 721 exchange guaranteed
No. A 721 exchange is sponsor-dependent and not guaranteed. Availability depends on the structure of the DST and the sponsor’s strategy.
Is this strategy liquid
DSTs are generally illiquid during the holding period. Liquidity may improve after a 721 exchange, depending on whether the REIT is publicly traded or offers redemption options.
When is this strategy not a good idea
This strategy may not be appropriate for investors who need short-term liquidity, prefer hands-on control, or have minimal capital gains.
How early should I plan before selling
Planning should begin before listing the property for sale to ensure proper 1031 timing and access to suitable DST offerings.
How does Washington State treat real estate capital gains
Washington State generally does not apply its capital gains tax to real estate sales. Most tax exposure for Spokane investors is typically federal.
Who should help me evaluate this strategy
A knowledgeable financial advisor working with your CPA and attorney should evaluate this strategy to ensure it fits your broader financial plan.
Final thoughts
For the right investor, the 1031 to DST and 721 exchange strategy can defer significant capital gains taxes, reduce management burden, improve diversification, introduce controlled liquidity, and enhance estate planning outcomes.
However, it requires careful planning, proper structuring, and coordination between your CPA, attorney, and financial advisor.
If you are considering selling highly appreciated real estate and want to evaluate whether this strategy fits your situation, working with an experienced Spokane financial advisor who understands advanced real estate tax planning is essential.
Talk with our Spokane Financial Advisor team
About the Author
Noah Schwab, CFP® is a financial advisor in Spokane, Washington, helping retirees with $ 1M+ maximize their 401(k) with Roth conversions and tax strategies.
- No commissions or insurance
- Investment management, tax, and financial planning
Noah Schwab, CFP®, is a Spokane financial advisor specializing in helping retirees with tax-efficient retirement income strategies, Roth conversions, and estate planning. This article is for educational purposes only and should not be considered tax or legal advice.
