Delaware Statutory Trust + 721 Exchange: How the Combo Works, Pros and Cons

How the combination works

Owners usually reach this combination by buying into a Delaware statutory trust that is tied to a sponsor's REIT. The offering documents give the REIT's operating partnership an option to acquire the trust's property in exchange for units, typically after a holding period set in the memorandum.

When the option is used, trust investors receive units under Section 721 instead of cash. Some sponsors also let investors contribute their interests on their own timetable.

The first step is the 1031 exchange. The second step is not a 1031 at all. It is a contribution to a partnership, which is why the deadlines stop and the future 1031 exchanges end. Whether to take part in any offering is a decision for your securities and legal professionals.

Pros of the combination

• The 1031 clock runs once, not every time a property sells.
• Trust interests can be sized to your proceeds, which limits boot.
• The later 721 step swaps a single-property trust for a share of a diversified operating partnership.
• No new capital-gain tax at the 721 step if it is done correctly (IRC 721(a)).
• Passive ownership throughout.
• Units held until death generally take a stepped-up basis (IRC 1014), which can erase the deferred gain and depreciation recapture.
• An older owner makes one set of decisions instead of a chain of them.

Cons and traps

• No more 1031 exchanges. A partnership interest is not like-kind real property (Treas. Reg. 1.1031(a)-3(a)(5)).
• Taxable exit. Redeeming units for cash or exchanging them for REIT shares triggers the deferred gain (IRC 731, 741).
• Two layers of fees. Trust selling costs and sponsor fees, then REIT and partnership fees. The SEC says non-traded REITs can charge upfront fees of up to 15 percent of the offering price.
• Disguised sale. Cash or debt relief near the contribution can be presumed a sale if it happens within two years (Treas. Reg. 1.707-3).
• Debt shift. If your share of liabilities falls in the partnership, the reduction can be a deemed cash distribution (IRC 752, 731).
• Built-in gain stays yours. If the partnership sells your contributed property, the gain is allocated to you (IRC 704(c)) unless a tax protection agreement covers it.
• Planning risk. A prearranged contribution right after a 1031 can invite questions about whether the exchange was really for investment. There is no statutory minimum holding period, so ask tax counsel how the offering is set up and how long the trust is held.
• Illiquid. Redemption programs of non-traded REITs can be limited, suspended or at a discount.

Compared with the alternatives

• Keep exchanging trusts: keeps 1031 options open, costs a new deadline and new fees every time. See 721 exchange vs 1031 exchange.
• Trust only: see Delaware statutory trust vs 721 exchange.
• Installment sale: no sponsor fees and you control the schedule, in exchange for buyer credit risk and no step-up on the unpaid note (IRC 691). See 1031 vs installment sale.
• Cash sale: tax now, full access to money.

These are tax facts, not advice about any security, and Hans does not sell securities. To model your own numbers against a cash sale, an installment sale and repeated exchanges, get the Big Sale Tax Analysis.

How the roll works, step by step

Step one is an ordinary 1031 exchange. You sell your property, a qualified intermediary holds the cash, you identify replacement property within 45 days and close within 180 days (IRC 1031(a)(3)). The replacement is an interest in a Delaware statutory trust that owns a building. Under Rev. Rul. 2004-86 the interest is treated as real property, so the exchange is valid.

Step two happens later, under the offering documents. The trust's property is contributed to the operating partnership of a REIT, and the trust's owners receive units. That is a Section 721 contribution, so no gain is recognized (IRC 721(a)). It is not a second 1031 exchange, so no new 45-day or 180-day clock runs. Your basis carries over from the old property to the trust interest, then to the units.

Forced-721 clauses and the sponsor's option

Many trust offerings that are tied to a REIT include a clause giving the REIT's operating partnership an option to acquire the trust's property for units.

Commentary describes two kinds: optional structures, where each investor chooses at the sale whether to take units, and forced structures, where investors have no choice and exchange on the sponsor's terms (Kiplinger).

A fair market value option, where the operating partnership may buy the trust's property at an appraised value for units, appears in some programs; I have not verified its terms against a specific offering (see the questions to ask the sponsor).

These are drafting choices, not Code rules, and they differ by sponsor.

Read four things before you sign. Who can trigger the contribution? Is there a minimum hold? What do you receive if you refuse, if refusal is possible? What happens to your deferred gain if the contribution fails to qualify? You are buying the trust interest and agreeing to the second step at the same time, so the exit is part of the price.

The held-for-investment question

Section 1031 requires that you hold both the old and new property for business use or investment (IRC 1031(a)(1)).

If the replacement is acquired with a plan to move it into an operating partnership right away, the IRS can argue you never held it for investment, only as a stop on the way to something that is not like-kind.

I have found no published IRS ruling that sets a safe holding period for a trust interest, so a figure such as two years comes from sponsor practice and counsel, not from the Code. The memorandum and your own attorney decide what is prudent on your timeline.

What ends when the 721 happens

Units are a partnership interest, and a partnership interest is not real property for Section 1031 (Treas. Reg. 1.1031(a)-3(a)(5)). From the day of the contribution, your runway for exchanges is over. Any gain left will come out as units are redeemed, or as the partnership sells property you contributed (IRC 704(c)(1)(A)). A redemption for cash is a taxable sale of the units.

Two traps sit near step two. A transfer of cash to you within two years of the contribution is presumed to be a sale of part of the property (Treas. Reg. 1.707-3(c)). And a reduction in your share of partnership debt is treated as a cash distribution, which is gain when it exceeds your basis (IRC 752(b), 731(a)).

The tax at each step, with the engine's numbers

Take a $4,000,000 sale with a $1,200,000 basis. A cash sale costs $720,753 in 2026. In the first step, a valid exchange with $200,000 of cash boot costs $49,928 that year, and the remaining deferred gain rides into the trust. Boot is taxed first as the highest-rate gain it can be, so a small amount of boot is expensive per dollar (about 25.0% here).

After the 721, the remaining $2,600,000 of gain comes out as units are redeemed. Redeeming one-fifth each year over five years, with $150,000 of other income, costs $547,465 in total, an effective rate of 21.1%.

Compare that with a cash sale at once: $173,288 less in tax here, though the five years of income lost is not counted. At death the remaining units can receive a fair market value basis (IRC 1014).

Frequently asked questions