Tax Smart Strategies for Landlords Looking to Retire: 1031 Exchange Alternatives
- Max Gallagher, CFP
- Oct 2
- 12 min read
How 1031 Exchanges, Delaware Statutory Trusts (DSTs), and 721 Exchanges (UPREITs) can help you defer taxes, simplify ownership, and protect your legacy.
Real Estate as a Wealth Building Tool
If you talk to many longtime landlords, they’ll tell you that investment property has been one of the best decisions they ever made. Real estate can provide tax-sheltered income, direct control over long-term appreciation, and a tangible sense of security. There’s just something nice about being able to go and physically touch your investment.
Those same landlords will also be the first to tell you that management is not as passive as the social media gurus would like to make it seem. Even still, for many, the positives outweigh the negatives and those that have taken the time to build their real estate business the right way, it’s led to financial success that can benefit multiple generations.
The Challenges of Managing Investment Property
It’s no secret that, even with a property manager, the daily grind of managing contractors and tenants, bookkeeping and cashflow management, and scheduling repairs and maintenance can grow tiresome. Even those with the most well-oiled business at some point may ask themselves:
“What’s next?”
And the answer to that question isn’t typically straightforward. Selling outright may seem like a logical step, but many will quickly realize what that means in terms of reduced monthly cashflow, a big capital gains tax bill, and estate planning implications to those who stand to inherit assets.
Let’s dive into each of these issues.
Three Biggest Mistakes When Selling Appreciated Real Estate
Loss of Income – One of the immediately felt impacts of selling a cash flowing property is the loss of rental income. To be fair, you will receive equity in the form of cash which can then be reinvested in all types of accounts and assets. A good advisor can easily recreate that stream of income in a number of different investments. Still, the reliability and predictability of losing a recurring stream of payments is a challenge that must be navigated and one that commonly prevents landlords from relinquishing a property. Even if that property is underperforming, overly-complex, or too time consuming.
Capital Gains Tax & Depreciation Recapture – Upon sale, the appreciation you’ve built up over decades can trigger significant capital gains taxes. We determine the capital gain by taking the difference between your cost basis (purchase price plus any capitalized improvements) and the sale price.
For example, say you purchased a property for $400,000 ten years ago and completed a $100,000 remodel shortly after purchase. Your cost basis in this property is $500,000. Now say you decide to sell that property for $1,500,000. The difference would be considered a $1,000,000 long-term (ie. held greater than 1 year) capital gain. This capital gain could be subject to federal taxes up to a maximum 20%, plus state taxes, and other potential taxes.
If you’re a high-earner living in California the marginal tax rate could be as much as 37.1% between Federal, State, NIIT, and Mental Health Tax. That tax bill can quickly erode a large portion of your nest egg.
But wait there’s more! Capital gains are not the only tax to be aware of when selling investment real estate. One of the reasons property can be a “tax-efficient” investment is because depreciation of the underlying structural asset (excluding land) can be claimed with the IRS to shelter income. The IRS allows owners of investment real estate to depreciate the structure over 27.5 years.
In the previous example, your approximate annual depreciation expense (which you claim but do not actually pay) would be: $420,000 (hypothetical cost basis excluding land which cannot be depreciated) divided by 27.5 (useful life) which equals ~$15,000. That’s $15,000 of income that can essentially be claimed tax-free!
But when selling a property, all of that great depreciation can come back to bite you.
In the previous example, you would have claimed about $15,000 of annual depreciation over the course of 10 years. Total depreciation claimed and tracked on your tax return would be about $150,000. Upon sale, this $150,000 is reclaimed based on depreciation recapture rules and taxed at a maximum rate of 25%.
Things get even trickier if you’ve completed a cost segregation study on the property or leveraged any other accelerated depreciation methods. This property can get taxed at your regular, higher ordinary income tax rates.
It doesn’t take long to realize this is the number one reason investors will stay in a property that they may otherwise sell.
Loss of Estate Planning Benefits – One of the less talked about reasons not to sell outright is a common planning tactic used to help the heirs who are set to inherit property avoid all of the taxes in the previous section. If the owner of an appreciated asset (property, stock, etc) holds until their death, their heirs may receive a “step-up in basis,” which bumps up the cost basis to the assets fair market value.
For example, in the previous example, say the owner of the property passed away and left the real estate to their child. That child would receive the property with a cost basis equal to the fair market value at date of death (ie. $1,500,000). This step up would even eliminate all accumulated depreciation and the corresponding tax liability. If they chose to sell at that price, the heir would owe a grand total of ZERO dollars in tax.
As you can tell, the step up in basis is a powerful tax tool that can wipe out decades of taxable gains in all kinds of appreciated assets.
Between the pitfalls mentioned above, it’s no wonder many landlords feel stuck. Torn between the burdens of active management and the financial consequences of selling.
1031 Exchanges as an Exit Strategy for Underperforming Property
Based on the challenges above, many property owners end up considering a 1031 exchange, which allows you to sell one property and roll the proceeds into another “like-kind” investment without paying taxes at the time of sale. Essentially, you’re exchanging your interest in one property for another while deferring taxes as the cost basis is carried over. It’s one of the most powerful tools in the tax code for real estate investors but requires strict adherence to IRS regulations to qualify.
When completing a 1031 exchange, we always recommend working with an advisor who can help navigate the following requirements:
Property that’s being sold and purchased must be used for investment purposes.
The sale proceeds must go directly to a Qualified Intermediary, an independent party who facilitates the funds for the exchange. Funds can never touch your bank account.
Upon sale, you have 45 days to identify a replacement property. Up to three properties can typically be identified.
Upon sale, you have 180 days to complete the purchase of the replacement property from the previously identified list.
Both properties must be in the United States.
To fully defer taxes, all funds must be reinvested into a replacement property of equal or greater value.
But while 1031 exchanges are extremely powerful, there’s a catch for those looking to retire from the active management of property. An exchange just replaces your interest in one property for another and still requires you to own and manage another piece of real estate. For those landlords who are seeking more freedom, this doesn’t exactly accomplish the goal.
That’s where lesser-known alternatives come in; Strategies that combine the tax benefits of a 1031 exchange, the ability to replace lost cashflow, and the freedom of passive investing.
Delaware Statutory Trusts (DSTs)
A Delaware Statutory Trust (DST) is an investment structure that allows multiple investors to hold a fractional interest in the holdings of the trust, typically institutional-quality real estate such as apartment complexes, office buildings, or industrial parks. This trust is originally established by a “sponsor” who oversees acquisition and ongoing management of the underlying property.
The beauty of the DST ownership structure is that this fractional ownership in the underlying real estate is considered like-kind replacement property and eligible for 1031 exchanges.
For example, in the previous example we had a property with a cost basis of $500,000 that was being sold for $1,500,000. The owner decides to complete a 1031 exchange into a DST. After some research, the owner finds a sponsor/operator with a good track record and an asset they’re excited about: a $15,000,000 apartment building located in the mid-west. They exchange the proceeds from their sale into a ~10% ownership stake in this new apartment building. Their equity stays the same at $1,500,000 and their cost basis of $500,000 carries over to the new investment. Taxes are completely deferred until they sell their interest in the replacement property.
Even though the new property is held in a trust, fractional owners still retain the benefits most real estate investors are looking for:
Income - As that property generates income from rental activities, it is distributed to shareholders.
Appreciation - As that property appreciates from market growth or improved operations, so does the value of your interest in the DST.
Depreciation – Even depreciation from the building and components can be passed along to shareholders to help shelter some income from taxes.
Basis Step-Up – If the owner holds this investment until they pass, their heirs receive the same stepped-up basis as they would any other appreciated property.
In addition to the benefits real estate investors know and love, a Delaware Statutory Trust also provides two big benefits that can be compelling for a certain type of investor:
Passive Management – Professional managers handle all aspects of management including leasing, maintenance, and operations. This is an ideal situation for someone looking to relieve themselves of the responsibilities of day-to-day management so they can focus on the things that matter most to them.
Diversification – Many landlords and real estate investors naturally have a concentrated portfolio, with significant equity in singular properties, geographic regions, and asset classes (ie. residential, commercial, industrial, etc). DSTs are an efficient way to broaden the exposure of your portfolio and reduce risk across multiple buildings, geographies, and asset classes.
While DSTs are a wonderful tax tool, we would never recommend making a decision based on the tax benefits alone. Due diligence is incredibly important when determining if this is a good fit for your personal financial situation and if a specific Delaware Statutory Trust is a good investment. At the end of the day, a DST must be attractive from a market, sponsor, asset, and financial perspective, or you can quickly lose the tax benefits.
With so many options available on the market, 24Acres Wealth assists our clients in making informed decisions on the alternative investment that is the best fit for their situation. Independent, objective advice allows our clients to feel confident and informed about their decisions with clarity around all the options available to them.
If you’d like a no-cost, no-obligation consultation on your financial plan and tax strategy, contact us.
721 Exchanges (UpREIT)
A 721 exchange, also known as an UPREIT (Umbrella Partnership Real Estate Investment Trust) transaction, allows property owners to contribute real estate into a REIT (ie. a fund that owns and operates income producing real estate) in exchange for Operating Partnership (OP) units. Institutional real estate investors can use the 721 exchange structure directly, contributing large properties into a REIT portfolio in a single transaction.
For non-institutional investors, this process may look a little different. Most individual landlords don’t exchange their property directly into a REIT. Instead, they complete a 1031 exchange into a Delaware Statutory Trust (DST), just as described above. The DST is often identified and structured for the potential of an acquisition by a REIT, meaning that at some point the REIT likely will acquire the DST’s underlying property via a 721 exchange. If you as the DST shareholder agrees to the acquisition, your DST fractional interests would be converted into OP units of the REIT through a 721 exchange.
This two-step process (1031 into a DST, then DST into a REIT via 721 Exchange) gives everyday investors access to a strategy historically reserved for institutions. It allows them to begin with the familiar 1031 rules, enjoy the passive benefits of DST ownership, and eventually transition into the scale, diversification, and liquidity features of a REIT structure.
For example, let’s return to our previous property sale scenario. A landlord sells their $1,500,000 property and completes a 1031 exchange into a DST that owns a $15,000,000 apartment building. Three years later, the DST goes full cycle and is eligible to be acquired by a national REIT that owns and operates apartment buildings across the US. At that time, the individual owner decides to proceed with the 721 exchange and their fractional DST interest is converted into OP units of the REIT. Their $1,500,000 equity (plus growth from the appreciation of the DST over 3 years) remains fully invested, and their $500,000 basis carries over into the new OP units. Capital gains taxes are deferred yet again.
DST shareholders will receive notice and the opportunity to exercise choice when a DST is absorbed by a REIT via a 721 exchange. They choices include:
Receive Cash – Sell your DST interest and pay taxes on unrealized gains.
Decline the 721 Exchange – This option will give you the ability to complete another 1031 exchange either into another DST or another piece of real investment property.
Accept the 721 Exchange – Your interest in the DST is contributed to a REIT in exchange for operating partnership units.
It is important to note that once you proceed with a 721 exchange, the underlying OP units are no longer eligible for 1031 exchanges. Taxes are still deferred but the only way to pull out of the REIT investment is to sell some/all of your shares and pay taxes.
Once a 721 exchange is completed, investors participate in the REIT’s portfolio performance, which could include hundreds to thousands of properties across multiple regions and sectors. Just like directly held property and DSTs, OP units often come with the following benefits:
Income – REITs are required to distribute at least 90% of taxable income (ie. rent) to investors. As an OP unit holder you’ll typically get cash distributions from operations on a quarterly basis.
Appreciation – As the REIT’s real estate portfolio appreciates, so does the value of your OP units.
Depreciation – Depreciation from the REIT portfolio can still be passed through, helping reduce and shelter taxable income.
Basis Step-Up – If REIT shares are held until death, heirs generally receive a step-up in basis, wiping out a lifetime of deferred gains.
In addition to these familiar benefits, 721 exchanges provide two features that make them particularly compelling for aging landlords over directly held property and even DSTs:
Liquidity & Flexibility – Shares can be gradually “cashed out” in smaller increments. Each sale of shares will come with a small, realized capital gain, but this finally allows investors to access incremental amounts of equity that’s been locked in their appreciated real estate. For example, in the previous example a REIT shareholder may sell $10,000 worth of shares which would be broken out as $6,667 of realized capital gain and $3,333 of tax-free basis return. We get there by understanding the total gain ($1m) relative to the value ($1.5m). Essentially, for every dollar of the REIT you sell, you’ll only pay capital gains tax on approximately 2/3rds of that amount (ie. $1m divided by $1.5M).
Diversification at Scale – While the diversification benefits of DSTs are great, REITs typically have much larger scale. Instead of being tied to one building or one DST mini portfolio, the investor now holds a fractional interest in hundreds to thousands of professionally managed, institutional grade properties worth hundreds of millions to billions, spanning multiple property types and geographies.
While UPREITs can be an elegant solution, they’re not without complexity. REIT policies, conversion rules, and sponsor quality vary significantly. Planning and due diligence is crucial as any small mistake during the process can result in meaningful consequences.
At 24Acres Wealth, we help clients evaluate these nuances so they can understand whether a particular path is aligned with their personal financial goals, income needs, and estate planning priorities.
If you’d like a no-cost, no-obligation consultation on your financial plan and tax strategy, contact us.
Which Path Is Right for You?
Both DSTs and 721 UPREITs address the same pain point for landlords looking to transition out of direct property management without handing a large portion of their wealth to the IRS. But with all of the options available to you, how do you decide which is best?
The answer is highly dependent on your goals, tax profile, liquidity needs, estate plan, and other factors of your full financial picture. Having a conversation with an advisor can be the difference between making a bad, good, and great decision.
1031 Exchange, DST, and 721 Exchange Considerations and Cautions
Like any investment or tax strategy, DSTs and 721 UPREITs come with rules, risks, and nuances. Here are a few to keep in mind:
Illiquidity - DST interests are typically not easily sold during the holding period. They’re meant to be long-term investments and thus should not be leveraged if you need access to the funds (beyond cash distributions) over the short-term.
Loss of Control - With both DSTs and UPREITs, you are no longer the decision-maker. Professional managers take the reins which is the core trade-off for passive income and one that many are okay with in order to remove yourself from the headaches that come with managing property.
Investment Risk – Like any investment whether it be a stock or a property, there is risk of losing money. That may come in the form of down markets, loss of rents, or operational failure but returns can never be guaranteed.
Due Diligence – As mentioned above, not all investments or sponsors are created equal. The quality of the underlying assets and managers matters enormously, and this risk can be mitigated with thoughtful analysis prior to commitment.
Professional Guidance - These strategies sit at the intersection of tax law, real estate, and estate planning. Working with an experienced advisor is essential.
The Bottom Line
For landlords who are ready to retire from the day-to-day responsibilities of property management but worried about capital gains or losing the step-up in basis, there are more options than just selling or swapping into another building.
Delaware Statutory Trusts and 721 UPREIT exchanges offer pathways to defer taxes, transition into passive ownership, and create a smoother wealth transfer to the next generation.
Take the Next Step
If you’ve been feeling stuck between the tax bill of selling and the burdens of holding, it may be time to explore these alternatives. With the right guidance, you can step away from the landlord role while still protecting the wealth you worked so hard to build.
If you’d like a no-cost, no-obligation consultation on your financial plan and tax strategy, contact us.
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