Editor’s note: This is part one of a two-part series about forced Section 721 UPREIT conversions when a Delaware statutory trust (DST) goes full-cycle and reaches the end of its hold period. Part two will discuss the flip side of these forced conversions, as well as preferred alternatives.
IMPORTANT MEMORANDUM
TO: All 1031 exchange, 721 exchange UPREIT and Delaware statutory trust investors
FROM: Dwight Kay, founder and CEO of Kay Properties & Investments
SUBJECT: Risks of forced DST-UPREIT conversions
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EXECUTIVE SUMMARY
In recent Delaware statutory trust (DST) offerings, some sponsors include forced Section 721 UPREIT conversions into perpetual-life REITs (non-traded REITs) at the end of the DST’s hold period.
Under this structure, investors receive potentially illiquid REIT (real estate investment trust) operating partnership (OP) units instead of cash.
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This memo outlines the key risks of forced UPREITs (umbrella partnership REITs) and explains why investors should prioritize traditional DSTs or DSTs with fully optional 721 UPREIT elections.
Here are four key risks of forced DST 721 UPREIT conversions:
1. Loss of control over exit
In a forced DST 721 UPREIT scenario, investors have no choice in the exit strategy — you must exchange your DST interests for REIT operating partnership units on the sponsor’s terms.
The timing and terms might not align with your personal financial strategy, and you effectively lose flexibility to choose whether or when to cash out or continue deferring taxes.
Investors are essentially locked in to the UPREIT without the ability to change course or pursue a different 1031 exchange at sale.
Investors who participate in a forced 721 UPREIT put themselves into a situation in which they won’t be able to evaluate the health of the final-destination REIT at the time of the 721 transaction.
This is problematic because the final-destination REIT might appear healthy at the time of the DST transaction, but when the DST is called into the 721 exchange transaction in a few years, the final-destination REIT could potentially have a completely different financial picture and risk profile.
2. Limited liquidity and redemption risks
Non-traded, perpetual-life REITs resulting from a 721 UPREIT conversion offer very limited liquidity compared with a straightforward property sale. The partnership units you receive are illiquid — they’re not publicly traded and can’t be quickly converted into cash.
While many non-traded REITs offer periodic redemption programs, those programs are typically restricted and not guaranteed as per the REIT’s offering documents. Such share redemption plans can be capped, oversubscribed, even suspended, especially in times of market stress.
Regulators often caution investors that non-traded REITs often involve a lack of liquidity and sometimes include uncertain early redemption provisions for investors.
In a forced UPREIT, this means you could be unable to liquidate your investment on your own timetable. Even worse, if many investors seek to redeem, the REIT might simply halt redemptions, as has occurred with some large perpetual-life REITs.
You give up the assured liquidity of a sale, and your ability to cash out depends on the REIT’s limited redemption policies (which the REIT can alter or pause at its discretion).
Many of the largest non-traded perpetual-life REITs have gated their liquidity provisions. Investors who might have been told they would have access to liquidity by their financial adviser can be stuck with an illiquid real estate offering. It could take them months or years to access liquidity.
3. Valuation opacity
A perpetual-life DST-sponsored REIT often uses internally assessed net asset values (NAVs) for its shares, which introduces valuation opacity.
Since there is no active market setting a transparent price, investors must rely on sponsor-provided and commissioned appraisals or NAV calculations, which can lack the transparency of open market pricing.
In a forced conversion, you surrender a straightforward payout (sale proceeds at market value) for an opaque stake in a larger portfolio.
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Determining what your new REIT units are truly worth can be difficult, and the valuation can be subject to conflicts of interest, as the sponsor is on both sides of the DST-to-REIT transaction. This opacity can obscure whether you’re getting fair value for your DST property.
In contrast, a direct property sale to an unaffiliated third party establishes a clear market value for your investment.
4. Tax deferral risks
While a 721 UPREIT conversion itself is generally not a taxable event, it can introduce complex tax risks down the line.
Once you hold REIT operating partnership (OP) units, you can no longer do a 1031 exchange on that investment, as OP units don’t qualify as like-kind property for 1031 purposes.
This means a forced UPREIT effectively cuts off your ability to continue deferring capital gains tax via future 1031 exchanges.
As a result, your tax deferral will end when you eventually liquidate your REIT units. Any conversion of your OP units into REIT shares or cash redemption is a taxable event that will trigger the capital gains you had deferred.
In other words, the tax bill is delayed but not eliminated, and you’ll encounter it again when exiting the REIT. You’ll also lose control of the timing of that taxable event.
If the REIT later forces a merger or compels conversion of your OP units to common shares, you could be hit with a poorly timed taxable capital gain.
There is also the risk that the REIT’s operating partnership might sell the underlying property you contributed, and without careful structuring or tax protection agreements, such a sale could unexpectedly trigger taxable gains to you as an OP unit holder.
In summary, a forced UPREIT can create an inevitable tax liability and take away the 1031 exit ramp that DST investors often rely on to continually defer taxes.
Many DST 721 UPREIT sponsors clearly state in their offering documents that they won’t provide a tax protection agreement to their investors.
This would leave the investors exposed. If the REIT were to sell its DST property that the DST investors contributed via a 721 exchange to the REIT, it would be forced to pay capital gains taxes on that contributed property.
In part two of this series, I will discuss the flip side of these forced conversions and describe why I firmly believe fully optional UPREIT conversions are far superior and what investors should be aware of before investing in any 721 UPREIT exchange.