721 Exchange Downsides: 7 Critical UPREIT Risks Every Investor Must Know
Before converting your property to REIT ownership, understand these seven critical risks that could permanently affect your tax strategy and investment flexibility.
Key Takeaway
A 721 exchange (UPREIT) permanently ends your ability to use 1031 exchanges for that equity. According to Anchor1031, the seven most significant downsides are: loss of 1031 flexibility, illiquidity, loss of control, REIT performance risk, forced conversion risk, tax implications at exit, and fee opacity.
A 721 exchange allows real estate investors to contribute property to a Real Estate Investment Trust (REIT) in exchange for operating partnership (OP) units, deferring capital gains tax under IRC Section 721. While this strategy offers tax deferral and passive income, it comes with downsides that investors must understand before proceeding.
Unlike a 1031 exchange where you can continue rolling your gains into new properties indefinitely, a 721 exchange is a one-way door. Once you convert to OP units, you cannot return to direct real estate ownership through tax-deferred means. This article covers the seven critical downsides you must evaluate before proceeding.
1. Permanent Loss of 1031 Exchange Flexibility
Important Consideration
Under IRC Section 1031(a)(2)(D), partnership interests are explicitly excluded from like-kind exchange treatment. When you contribute property to a REIT via Section 721, you receive operating partnership units, which are partnership interests, not real property.
This means your 721 exchange is your final tax-deferred real estate transaction for that equity. You cannot:
- Roll OP units into a new property via 1031
- Continue the "swap until you drop" deferral strategy
- Use the equity for future like-kind exchanges
Many investors use repeated 1031 exchanges to defer taxes across decades. A 721 exchange ends that flexibility permanently. For a balanced view of both sides, see our guide on 721 exchange pros and cons via DST.
2. Illiquidity and Lockup Periods
Understanding the two-step liquidity process is essential before committing to a 721 exchange. When you complete a 721 exchange, you receive Operating Partnership (OP) units, which are partnership interests in the UPREIT structure. These OP units are a different security than REIT shares and cannot be freely bought or sold on any exchange.
To access any liquidity, you must first convert your OP units into REIT shares, and then redeem those REIT shares through the REIT's redemption program. Each step has its own restrictions and timeline.
Step 1: OP Units to REIT Shares
12-24 Month Lockup Period
Most OP units cannot be converted to REIT shares for 1-2 years after issuance. During this period, you hold partnership interests with no path to liquidity.
Step 2: REIT Shares to Cash
Quarterly Redemption Windows
After converting to REIT shares, non-traded REITs typically offer limited redemption programs with quarterly windows and volume caps.
Sponsor Discretion
The REIT sponsor often controls conversion timing, may impose blackout periods, and can suspend redemptions in stressed markets.
Before pursuing a 721 exchange, understand the redemption structure of the REIT you will eventually convert into. Ask about quarterly redemption windows, volume caps, any discounts to NAV on early redemptions, and historical redemption fulfillment rates. If the REIT has suspended redemptions in the past or imposes significant waiting periods, factor that into your liquidity planning. Compare this to a DST investment with a defined hold period and exit timeline.
3. Loss of Control Over Property Decisions
After a 721 exchange, you become a passive limited partner with no control over property operations, financing, or disposition. This represents a fundamental shift from active to passive real estate ownership.
What You Give Up
Property Operations
- No tenant selection or lease negotiation
- No capital improvement decisions
- No property management oversight
Financial Decisions
- No refinancing control
- No sale timing decisions
- No distribution policy input
For investors who value the "trash, toilets, and tenants" control of direct ownership, this passive structure may feel like a significant loss. All operational decisions are made by the REIT sponsor and management team.
4. REIT Performance and Management Risk
Your investment outcome becomes tied to the REIT's overall performance, management quality, and market conditions, rather than your individual property's fundamentals.
Risk Factors
Market Volatility
Publicly traded REIT shares experience daily price fluctuations based on interest rates, market sentiment, and sector trends, not just property fundamentals.
Management Risk
Poor acquisition decisions, excessive leverage, or misaligned sponsor incentives can damage returns for all unitholders.
Sector Concentration
Many REITs focus on specific property types. If that sector weakens (e.g., office, retail), your entire investment is affected.
Unlike direct property ownership where you control your exposure, REIT investors are subject to the portfolio-level decisions and performance of the entire organization. To see how one investor navigated these risks, read our hotelier 721 UPREIT case study.
5. Forced Conversion Risk: Hardwired vs. Hybrid Structures
Not all 721 exchanges are voluntary. Some DST structures force all investors into UPREIT conversion at a predetermined time, eliminating exit flexibility.
| Feature | Hardwired (Required) UPREIT | Hybrid (Optional) UPREIT |
|---|---|---|
| Conversion Timing | Mandatory at 2-3 years | Optional at 2-5 years |
| Exit Options | OP units only | Cash, 1031, or OP units |
| 1031 Flexibility | Lost at conversion | Preserved if cash exit |
| Investor Control | None (sponsor decides) | Choice at exit |
| Risk Level | Higher | Lower |
Due Diligence Reminder
6. Tax Implications at Exit
A 721 exchange defers capital gains tax, but it does not eliminate it. The built-in gain from your original property carries over to your OP units under IRC Section 704(c) and will be recognized when you exit.
Taxable Events
Converting OP Units to REIT Shares
This is typically a taxable event under IRC Section 731(a), triggering recognition of deferred gains.
Selling REIT Shares
Any appreciation in REIT share value will be taxed as capital gains upon sale.
REIT Distributions
REIT dividends are generally taxed as ordinary income, often at higher rates than long-term capital gains.
Estate Planning Note
Unlike direct real estate, where the investor controls when gains are realized through sales and exchanges, REIT investors do not control the timing or character of taxable distributions, which can include ordinary income or capital gains when the REIT sells assets.
7. Fee Opacity and Ongoing Costs
REIT fee structures are often less transparent than DST offerings, with costs embedded in the REIT's operating expenses rather than disclosed upfront.
Common UPREIT Fee Layers
| Fee Type | Typical Range | Timing |
|---|---|---|
| Asset Management | 0.5-1.5% of NAV annually | Ongoing |
| Property Management | 2-4% of gross revenue | Ongoing |
| Acquisition Fees | 1-2% of purchase price | Upfront |
| Disposition Fees | 1-3% of sale price | At exit |
| G&A Expenses | Varies widely | Ongoing |
For more on how private REITs work with DSTs and 721 exchanges, see our private REITs guide.
When You Should Avoid a 721 Exchange
According to Anchor1031, a 721 exchange is not appropriate for every investor. Consider avoiding this strategy if any of the following apply:
You want to continue using 1031 exchanges
If you plan to defer taxes indefinitely through repeated exchanges, a 721 ends that strategy permanently.
You value control over property decisions
If managing tenants, capital improvements, and sale timing is important to you, passive REIT ownership will feel limiting.
The structure is hardwired with no alternatives
Forced UPREIT conversions remove your ability to choose a cash exit or 1031 at the end of the DST hold period.
The sponsor lacks tax protection agreements
Some sponsors do not provide tax protection, leaving you exposed to unexpected gain recognition if properties are sold.
721 Exchange Due Diligence Checklist
Before proceeding with a 721 exchange, Anchor1031 recommends asking these critical questions:
Is this a hardwired or hybrid UPREIT structure?
What is the lockup period before OP units can be converted?
What are the REIT's redemption policies and limitations?
What are all the fee layers (asset management, property management, G&A)?
What is the REIT's track record and management experience?
Am I comfortable never doing a 1031 exchange with this equity again?
Frequently Asked Questions
What are the downsides of a 721 exchange?
According to Anchor1031, the seven main downsides of a 721 exchange are: (1) permanent loss of 1031 exchange flexibility since OP units are not like-kind property, (2) illiquidity in the first 1-3 years before you can convert to REIT shares, with potential liquidity after conversion, (3) loss of control over property decisions as you become a passive limited partner, (4) REIT performance and management risk exposure, (5) forced conversion risk in 'hardwired' structures where the sponsor controls timing, (6) tax implications at exit when converting OP units triggers capital gains, and (7) fee opacity compared to DSTs which disclose costs upfront. The most significant downside is the irreversible loss of 1031 exchange optionality. Consult your CPA and financial advisor before proceeding.
Can I do a 1031 exchange after a 721 UPREIT conversion?
No. Once you complete a 721 exchange, you receive operating partnership (OP) units, which are partnership interests under IRC Section 1031(a)(2)(D). Partnership interests are explicitly excluded from 1031 exchange eligibility. This means a 721 exchange is your final tax-deferred real estate move for that equity. You cannot roll OP units into another property via 1031. This permanent loss of exchange flexibility is why Anchor1031 emphasizes that 721 exchanges should only be considered for investors whose goals align with this strategy.
What is the difference between a hardwired and hybrid UPREIT?
A hardwired UPREIT (also called a 'required' UPREIT) requires all DST investors to convert to OP units at a predetermined time (typically 2-3 years), with no option to exit via 1031 exchange or cash. A hybrid UPREIT (also called an 'optional' UPREIT) offers flexibility: after the hold period (typically 2-5 years), investors can choose between (1) cash buyout enabling another 1031 exchange, (2) 721 conversion to OP units, or (3) in some cases, a combination. According to Anchor1031, hybrid structures are generally more investor-friendly because they preserve optionality. Always verify which structure a DST uses before investing.
Are 721 exchange OP units liquid investments?
No, operating partnership units from a 721 exchange are illiquid securities. Unlike publicly traded REIT shares, OP units cannot be freely sold on an exchange. Most have lockup periods of 12-24 months before conversion to REIT shares is permitted. Even after conversion, non-traded REIT shares have limited redemption programs with quarterly windows, volume caps, and potential discounts to NAV. The sponsor often has discretion over conversion timing and terms. If you need liquidity within 3-5 years, a 721 exchange may be appropriate if the REIT has a strong track record of honoring redemptions in full. However, redemption programs are not guaranteed and may be suspended or limited during market stress. Consult your financial advisor about liquidity needs before proceeding.
When should I avoid a 721 exchange?
According to Anchor1031, you should avoid a 721 exchange if: (1) you want to continue using 1031 exchanges to defer taxes indefinitely, (2) you value control over property decisions like tenants, renovations, and sale timing, (3) you are uncomfortable with REIT market volatility and sponsor risk, or (4) you prefer having the option to do a 721 rather than being required to do one. A 721 exchange is best suited for investors who are ready to fully exit active property ownership, prefer passive REIT income, want diversification across multiple properties and markets, and are pursuing estate planning strategies.
Bottom Line
While this article focuses on the downsides of 721 exchanges, there are also significant potential upsides including liquidity options, passive income, and estate planning benefits. For a balanced view of both the advantages and disadvantages, see our complete guide on 721 exchange pros and cons.
A 721 exchange can be an effective strategy for investors who have decided to transition from active real estate ownership to passive REIT income, particularly those planning to hold until death for the step-up in basis. These are important considerations to evaluate carefully.
The change in 1031 exchange eligibility is the most critical factor to understand. Once you convert to OP units, 1031 exchange treatment is no longer available for that equity.
Consult your CPA before making this decision. Also consult with your financial advisor and estate planning attorney to ensure this strategy aligns with your overall investment goals and tax situation.
About the Author
Trevor Sybertz, Partner
Trevor Sybertz is a Partner at Anchor1031, where he specializes in educating clients about 1031 exchanges, private real estate offerings, and REITs. With over a decade of experience in commercial real estate and capital markets, Mr. Sybertz has helped clients invest more than $100M in equity across a wide range of real estate assets and markets. Previously, he served as a Director at RealtyMogul, and before that as Assistant Vice President of Institutional Equity Sales at Keefe, Bruyette & Woods where he covered commercial mortgage REITs and international equities.
Sources
This article references the following authoritative sources:
- Tax Code:26 U.S.C. Section 721 - Nonrecognition of Gain or Loss on Contribution
- Tax Code:26 U.S.C. Section 731 - Extent of Recognition of Gain or Loss on Distribution
- Tax Code:26 U.S.C. Section 1031 - Exchange of Real Property Held for Productive Use
- Tax Code:26 U.S.C. Section 1014 - Basis of Property Acquired from a Decedent
- Treasury Regulation:26 C.F.R. Section 1.721-1 - Nonrecognition of Gain or Loss on Contribution
Not Sure if a 721 Exchange is Right for You?
Our team can help you evaluate whether a 721 exchange, DST investment, or continued 1031 exchanges best fit your investment goals.
Disclosure
Tax Complexity and Investment Risk
Tax laws and regulations, including but not limited to Internal Revenue Code Section 1031, bonus depreciation rules, cost segregation studies, and other tax strategies, contain complex concepts that may vary depending on individual circumstances. Tax consequences related to real estate investments, depreciation benefits, and other tax strategies discussed herein may vary significantly based on each investor's specific situation and current tax legislation. Anchor1031, LLC and Great Point Capital, LLC make no representation or warranty of any kind with respect to the tax consequences of your investment or that the IRS will not challenge any such treatment. You should consult with and rely on your own tax advisor about all tax aspects with respect to your particular circumstances. Please note that Anchor1031 and Great Point Capital, LLC do not provide tax advice.
The information contained in this article is for general educational purposes only and does not constitute legal, tax, investment, or financial advice. This content is not a recommendation or offer to buy or sell securities. The content is provided as general information and should not be relied upon as a substitute for professional consultation with qualified legal, tax, or financial advisors.
Tax laws, regulations, and IRS guidance regarding 1031 exchanges are complex and subject to change. Information herein may include forward-looking statements, hypothetical information, calculations, or financial estimates that are inherently uncertain. Past performance is never indicative of future performance. The information presented may not reflect the most current legal developments, regulatory changes, or interpretations. Individual circumstances vary significantly, and strategies that may be appropriate for one investor may not be suitable for another.
All real estate investments, including 1031 exchanges, are speculative and involve substantial risk. There can be no assurance that any investor will not suffer significant losses, and a loss of part or all of the principal value may occur. Before making any investment decisions or implementing any 1031 exchange strategies, readers should consult with their own qualified legal, tax, and financial professionals who can provide advice tailored to their specific circumstances. Prospective investors should not proceed unless they can readily bear the consequences of potential losses.
While the author is a partner at Anchor1031, the views expressed are educational in nature and do not guarantee any particular outcome or create any obligations on behalf of the firm or author. Neither Anchor1031 nor the author assumes any liability for actions taken based on the information provided herein.