Articles / Tax Deferral & Mitigation Strategies / 721 Exchange

The 721 Exchange allows an investor to exchange ownership in a single asset with units in an operating partnership with multiple assets. This transaction is used for clients wanting to diversify their holdings without paying capital gains taxes.

The 721 Exchange, or UPREIT: A Simple Introduction

The 721 exchange, similar to the 1031 exchange, allows an investor to defer capital gains taxes while relinquishing control of a property held for business or investment purposes.

Both tax mitigation strategies offer investors strong alternatives to a traditional sale, in which taxes can exceed 20--30% of capital gains (use our capital gains tax calculator to estimate yours).

The 1031 exchange, which allows an investor to defer capital gains taxes by selling investment property and reinvesting the proceeds in a like-kind asset, may not meet the goals of some investors. For example, an investor may be attracted to the stable income, tax benefits, and potential appreciation that can be provided by a REIT investment, which would not satisfy the requirements for a 1031 exchange.

In a 721 exchange, however, a real estate investor may defer capital gains taxes on the disposition of a property while acquiring shares in a REIT.

This article answers the following questions:

  1. How does a 721 exchange work?
  2. What are the primary benefits of a 721 exchange?
  3. Can an investor combine a 1031 exchange with a 721 exchange?
  4. Can an investor perform a 1031 exchange aftera 721 exchange? 

How does a 721 exchange work?
To complete a 721 exchange, there are several firms that specialize in the conversion of individually owned property to institutional grade property and then “UPREIT” using the 721 exchange. This process involves and investor selling their investment or business property and completing a 1031 exchange. The “relinquished property” is exchanged for a “like-kind” property with similar or greater value. The “replacement property” then must be held for investment purposes. This typically means holding the property as a rental or business property for 24 months, which qualifies the property for 1031 capital gains tax deferral. This “replacement property”, after being held for 24 months can be contributed to a REIT for Operating Partnership units based on the value of the property. These Operating Partnership units will subsequently be exchange for a direct ownership of REIT shares.

721 Exchange Infographic

What are the primary benefits of a 721 exchange?
Passive Income. Owning shares of a REIT is a passive investment into the REIT. At formation, managers will be appointed to oversee the management of the REIT and the properties that are included in said REIT. This allows investors to have a hands-off approach while the managers handle the day to day decision making process for the portfolio of assets. The investors will receive communication about acquisitions, dispositions, and distributions, but will not be involved in the formulating of any of these decisions.

Tax Advantages. Due to the structure of a 721 exchange, the gains on the sale of a property will be differed. In a typical sale, the gains that are realized as part of the sale would be subject to tax. This tax plus the tax on depreciation used to offset property taxes can sometimes exceed 25% of the gains you would receive upon sale. This leaves the investor with a substantially less amount of capital that can be used for another investment. With a 721 exchange, the investor would avoid the costly taxes and be able to use 100% of the gains on sale to purchase shares of a REIT. This strategy must be weighed against the fees that are required to complete the 721 exchange in order to purchase the REIT shares.

 Diversification. Due to the 721 exchange allowing an investor to purchase shares of a REIT, there are numerous diversification benefits. Generally speaking a REIT will have properties located in many different geographic locations, as well as having tenant, industry, and sometimes asset class diversification. As a shareholder of the REIT, the investor would no longer have their interests in a single asset. The REIT will provide the similar benefits of appreciation of the Real Estate, depreciation tax shelter, and income (in the form of dividends).

Estate Planning. When an investor is preparing to pass down their assets to their next of kin, the 721 exchange is a strategy that is often used and is beneficial. Physical Real Estate is often difficult to sell and can lead to conflicts in the division of the assets. However, if the estate should exchange into a 721, they will still receive all of the benefits during their lifetime, and upon passing, the shares can be split equally and either held or liquidated by the heirs of the trust. Because the shares are passed through a trust, the heirs will receive a step-up in basis and will avoid all capital gains and depreciation recapture taxes that were deferred by the estate. 

Can an investor combine a 1031 exchange with a 721 exchange?
There are requirements for a REIT to acquire property through a 721 exchange. Each REIT will have a specific investment criteria that they use to identify and acquire property. In general, a REIT will look to acquire property that is institutional-grade real estate. It is uncommon for an individual owner to own this type of property, however it is possible. For investors who are an owner of this type of property, a 721 is possible, however for those who do not own this type of property, a 1031 may be utilized to purchase a fractional interest in institutional grade property. By completing a 1031 exchange, an investor can exchange individually owned property for a fractional interest in institutional grade property. When the 1031 exchange is completed, investors may have the opportunity to complete a 721 exchange that will convert their fractional interest in property into a fractional ownership of a REIT.

1031 to 721 Infographic

Can an investor perform a 1031 exchange after a 721 exchange?
REIT shares do not have the ability to be used in a 1031 exchange, and therefore once a 721 exchange is completed, this is the end of the line for deferred capital gains tax. If the shares of the REIT are sold, or the REIT sell a portion of the portfolio and returns capital gains to the investors, the investors will be required to pay their capital gains tax as the sale of the shares is considered a taxable event.

Written By: Staff

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