A 721 exchange allows real estate investors to defer capital gains taxes by exchanging property for operating partnership (OP) units in an Umbrella Partnership Real Estate Investment Trust (UPREIT). This strategy offers access to institutional-grade properties and potential passive income, without the responsibility of direct property management. Understanding how a 721 exchange works can help you determine if it aligns with your investment goals.
How the 721 Exchange Works
In a 721 exchange, the investor’s real estate is contributed to an UPREIT—a specialized REIT that accepts property in exchange for a fractional interest in the REIT. This allows investors to indirectly own a share of the REIT’s entire portfolio through operating partnership (OP) units. The 721 exchange has some similarities to the 1031 exchange, which is one of the top tax planning strategies for real estate investors.
Here’s how the 721 exchange process works:
- Transfer of Property: The investor transfers their relinquished property, which was held for business or investment use, to the REIT’s operating partnership.
- Receipt of OP Units: In return, they receive OP units instead of cash. The units have the same value as the relinquished property, so this doesn’t create a tax event. The units symbolize fractional ownership in the REIT’s portfolio and allow investors to benefit from the same distributions as direct partners.
- Conversion to REIT Shares: OP units can be converted into shares after a specific holding period defined by the REIT. This offers liquidity and the option to sell the shares.
Two Types of 721 Exchanges
There are two types of 721 exchanges:
- Single-Step Exchange: This method is common among institutional investors. The REIT’s operating partnership directly acquires the investor’s relinquished property, and the investor receives OP units in return.
- Two-Step Exchange: More typical for individual investors, this process starts with a 1031 exchange where the investor sells their property and reinvests in a Delaware Statutory Trust (DST). Subsequently, the REIT acquires the DST and provides OP units in exchange.
721 Exchange vs 1031 Exchange: Key Differences
If you are familiar with the 1031 exchange, you may be curious about how the 721 exchange compares. While both options provide tax deferral benefits, they operate differently and serve distinct types of investors.
Structure of the Exchange
- A 1031 exchange involves swapping one investment property for another “like-kind” property to defer capital gains tax. It must adhere to strict IRS timelines, requiring identification of a replacement property within 45 days and completion of the exchange within 180 days.
- In contrast, a 721 exchange allows an investor to contribute their property to a REIT, receiving OP units that can later be converted into shares. This approach provides greater flexibility since there’s no need to replace one property with another.
Type of Ownership Interest
- In a 1031 exchange, the investor retains direct ownership of the replacement property. This often requires ongoing active management of the property.
- A 721 exchange shifts ownership into OP units within the REIT’s operating partnership, meaning the investor becomes a fractional owner of the entire portfolio. This eliminates the need for hands-on management.
Tax Implications
- Both exchanges defer capital gains taxes and depreciation recapture. However, converting OP units into REIT shares can trigger a taxable event if the shares are sold. Engaging a CPA with tax planning services is crucial for navigating these complexities and developing strategies that align with your financial goals.
- A 1031 exchange allows indefinite tax deferral through subsequent property exchanges, but is limited to real property transactions.
Key Benefits of a 721 Exchange
A 721 exchange offers various advantages for investors looking to diversify portfolios and defer taxes.
Access to Institutional-Grade Properties
Investors gain access to a portfolio of high-quality, institutional-grade properties that could otherwise be out of reach as an individual investor. This offers potential for capital appreciation and steady passive income through the REIT’s diversified portfolio.
Tax Deferral and Avoidance of Depreciation Recapture
One of the primary benefits of a 721 exchange is the ability to defer capital gains taxes and depreciation recapture on property sales, providing substantial tax advantages for investors selling investment property. An investor can continue to defer taxes for as long as they hold onto the OP units.
Estate Planning Tool
A 721 exchange can be a useful estate planning tool. OP units and shares can be easily transferred to heirs, simplifying inheritance compared to disposing of physical real estate.
Potential Drawbacks of a 721 Exchange
A 721 exchange does have a few potential downsides that you should understand clearly.
Loss of Direct Ownership
Direct ownership of the real estate is given up when an investor contributes property. Instead, they own a fractional interest in the REIT’s portfolio through OP units. This may not appeal to investors who prefer hands-on control of their properties.
Potential Taxable Event on Conversion
While a 721 exchange defers taxes initially, converting OP units into REIT shares and subsequently selling those shares can trigger a taxable event. Investors should plan accordingly and consult tax advisors to understand the full implications.
Limited Liquidity of OP Units
Although REIT shares are often publicly traded and relatively liquid, the OP units that investors initially receive may not be immediately convertible into shares. Investors may need to wait for a specified period before gaining liquidity.
Market Volatility
Investors who exchange property through a 721 UPREIT into a publicly traded or soon-to-be public REIT will have their OP units tied to the fluctuating stock market. This means investors transition from owning private real estate to holding stock-based assets. As Warren Buffett once said, “The stock market is designed to transfer money from the Active to the Patient“—highlighting the long-term mindset that is necessary when navigating such transitions.
Investment Risk
Even the most well-managed REITs can encounter unforeseen challenges, such as interest rate hikes, economic downturns, or global events like pandemics. Past performance does not guarantee future outcomes.
Forced Capital Gains
If the REIT’s management decides to sell an asset, all shareholders are affected. Instead of reinvesting the proceeds into another property, the REIT may choose to return the capital to investors, which creates a forced taxable event for shareholders. This scenario can result in capital gains being realized without the investor’s control.
Situations Where a 721 Exchange Makes Sense
By consulting with firms specializing in real estate CPA services, such as Alpine Mar, investors can determine if this strategy aligns with their investment objectives and risk tolerance. A 721 exchange may not be suitable for every real estate investor, but there are specific scenarios where it can be highly advantageous.
Investors Seeking Passive Income
Investors who are looking for passive income without the responsibilities of managing properties may benefit from the 721 exchange. By converting real estate into OP units and eventually REIT shares, investors can enjoy the income generated by the REIT’s portfolio without the burden of active property management.
Investors Interested in Diversification
For those looking to diversify their real estate holdings, a 721 exchange provides access to a diversified portfolio of properties, reducing investment risk. Instead of relying on a single property, investors can benefit from the performance of the entire REIT portfolio.
Wealth Transfer
A 721 exchange offers a seamless way for real estate investors to transfer wealth to their heirs. By converting OP units into REIT shares, investors can easily divide their assets among heirs. These shares are more liquid than physical real estate, simplifying the process of inheritance.
Additionally, heirs benefit from a step-up in basis, meaning the taxable value of the shares is reset to the fair market value at the time of the investor’s passing, reducing potential tax liabilities. Heirs can choose to retain the shares and continue receiving dividends or liquidate them for cash.
Tips When Executing a Direct 721 Exchange
If a 721 exchange seems like the right strategy for you, here are some quick tips to help ensure a smooth, stress-free process.
- Find a Qualified REIT
Begin by identifying a REIT that accepts property contributions through a 721 exchange. Not all REITs offer this option, so it’s essential to partner with one that aligns with your investment goals. - Value the Property
Work with appraisers and tax advisors to determine the value of your property before contributing it to the REIT. This ensures that you receive a fair number of OP units in exchange for your real estate. - Complete the Exchange
Once the property is valued and the REIT is selected, contribute your property to the REIT’s operating partnership. In return, you’ll receive operating partnership units that represent your fractional ownership in the REIT’s portfolio.
Unlock the Benefits of a 721 Exchange
A 721 exchange presents a unique opportunity for real estate investors to defer taxes while accessing a diversified portfolio of institutional-grade properties. This strategy simplifies wealth transfer to heirs and allows potential passive income without the demands of active property management.
Understanding the benefits and risks associated with a 721 exchange is crucial. Careful planning and consultation with tax professionals will help investors make informed decisions aligned with their financial goals.
