721 Exchange
Investors have many investment vehicles available to them depending on their investment goals and financial situation.
721 exchanges are lesser-known 1031 exchange alternative, yet these exchanges offer numerous benefits.
A 721 exchange is a type of real estate exchange that allows investors to contribute property to an umbrella partnership real estate investment trust(UPREIT) in exchange for units of equity interest in the operating partnership of the REIT. These exchanges allow investors to defer capital gains taxes from selling their property and receive dividends from the UPREIT. Investors should understand the details of performing a 721 exchange to decide whether the transaction might be right for them.
With a 721 exchange, you can transfer property into a REIT tax-free, diversifying your portfolio and enhancing liquidity. Discover if this is right for you!
What is a 721 Exchange(UPREIT)?
A 721 exchange is an exchange of real estate property for units in an open partnership(OP). The units can then be converted into shares in a real estate investment trust (REIT). The property being sold cannot be personal property and must be held for investment or business purposes to qualify for a 721 exchange. The Internal Revenue Service (IRS) describes these exchanges in Section 721 of the Internal Revenue Code (IRC).
A 721 exchange only triggers a taxable event when the investor redeems their shares, which they can do all at once or over time. Redeeming over time may allow the investor to take advantage of more favorable tax rates if they are in a lower tax bracket. Investors can earn steady dividend income from their units in the UPREIT and may benefit from several other advantages of 721 exchanges.
How Does a 721 Exchange Work?
IRC Section 721 states that if a property is contributed to a partnership in exchange for an interest in the partnership, no gain or loss will be recognized from the exchange. A 721 exchange does not trigger a taxable event, and the IRS will not collect taxes on any realized capital gains from the property sale.
The 721 exchange process typically follows these steps:
The investor contributes their relinquished property to the umbrella partnership, also called the operating partnership(OP), of an UPREIT
The property contributor receives units of interest in the umbrella partnership and becomes a unitholder
The OP maintains ownership of the properties and distributes the income to the unitholders
OP unitholders may choose to exchange OP units for REIT shares, which could be more easily sold
To understand how this transaction works, you must first understand an UPREIT structure
Difference Between a 721 Exchange and a 1031 Exchange
Like a 721 exchange, a 1031 exchange allows investors to defer capital gains taxes when relinquishing control of an investment property. While 1031 exchanges and 721 exchanges are similar, there are several significant differences between these types of transactions. Here are two main distinctions to note when comparing a 721 exchange vs. a 1031 exchange:
Types of assets being exchanged: In a 721 exchange, the investor relinquishes control of a real estate property in exchange for units of equity interest in the operating partnership. Investors must perform 1031 exchanges with like-kind real estate properties. A 721 exchange would not satisfy the requirements for a 1031 exchange because the units of equity interest are not of the same character or nature as the real estate property. More details of this distinction are addressed below.
Timeline: Investors in 721 exchanges don’t have to follow a specific timeline. However, investors must perform the 1031 exchange process within a strict deadline. After selling their relinquished property, investors have 45 days to identify replacement properties for their exchange and 180 days from the date of the sale to purchase a property.
What is an UPREIT?
An UPREIT allows investors to exchange their properties for units in the UPREIT. Generally, any REIT that allows property-for-share exchanges under IRC Section 721 can be considered an UPREIT. UPREITs managers handle the administration and management of the properties within the REIT’s portfolio to generate revenue. The UPREIT then distributes income to unitholders. If a unitholder liquidates their units or converts their units to REIT shares, it creates a taxable event.
What Is a DownREIT?
A DownREIT is a REIT alternative developed from UPREITs that also allows investors to contribute property in exchange for units in the operating partnership. The difference between an UPREIT vs. a DownREIT is that a DownREIT allows investors to become partners in a limited partnership agreement with a REIT instead of operating under an umbrella partnership.
An investor may choose a DownREIT because they believe the value of their property will appreciate more than the REIT-owned properties. Rather than exchanging properties for units in the operating partnership, a real estate investor contributes their real estate to the operating partnership in exchange for units in the operating partnership. The operating partnership then leases the property to the REIT, which operates the property and pays rent to the operating partnership. The investor receives a portion of the rental income in proportion to their units in the operating partnership.
Another distinction between a DownREIT and UPREIT is that DownREITs may not have the same tax advantages as UPREITs if the investor fails to structure the transaction properly.
What are the Primary Benefits of a 721 Exchange?
A 721 tax-deferred exchange can provide investors with several unique benefits. Understanding potential 721 exchange pros and cons can help you decide whether this transaction fits your investment goals. The advantages of a 721 exchange can vary depending on the specific structure and agreements in place. Consider the potential benefits of performing a 721 transaction:
Passive Income
Tax Advantages
Diversification
Estate Planning
What Situations Would be Appropriate for Considering 721 Exchange?
Investors in various situations could decide to complete a 721 exchange. Here are a few instances where an investor could consider a 721 exchange:
They have surplus property generated by consolidations
They want to defer taxes when selling real estate
They prefer to avoid property management responsibilities
They want to diversify their assets by exchanging a single property interest in a portfolio
They want to receive consistent passive investment income
What Are the Potential Disadvantages of a 721 Exchange?
Although 721 exchanges can provide investors with some significant advantages, there may also be some cons. Consider some of the potential drawbacks of performing a 721 exchange:
Lack of Investor Involvement
Lack of Control in triggering a taxable event
Inability to use the property in a 1031 exchange
What Is a Good 721 Exchange Candidate Property?
In rare cases, UPREITs may identify properties they consider ideal for a 721 exchange. The following properties could be good choices for this type of exchange:
A property with a third-party tenant.
Properties that meet the REIT investment criteria, which can vary.
Can You Combine a 1031 Exchange With a 721 Exchange?
Investors can sometimes combine a 1031 exchange with a 721 exchange to ensure the property they want to contribute to the operating partnership meets the acquisition criteria of the REIT they want to invest in. This strategy can be used when the property an investor owns doesn’t align with the REIT’s requirements.
In some cases, the investor may decide to perform a 1031 exchange to acquire a property that does meet the REIT’s criteria. The investor must then demonstrate their intent to hold the property for business or investment use to IRS. There is no requirement for how long to hold the property, but many investors choose to hold it for 12 to 24 months. After that time, they can contribute the 1031 exchange property to the REIT in exchange for units in the operating partnership.
Investors can also complete a 721 exchange with a Delaware Statutory Trust (DST) property to acquire a fractional interest in property that meets the criteria of the REIT. This process begins with the investor investing in a DST that has a 721 option and acquiring fractional ownership in an institutional-grade property. After a sufficient holding period, the sponsor would contribute the property to the REIT in exchange for OP units. This is becoming a more common option with DST sponsors as an added benefit to investors.
Can You Perform a 1031 Exchange After a 721 Exchange?
Investors cannot use units in a UPREIT to complete a 1031 exchange. 1031 exchanges can be made indefinitely as long as the investor owns the property they want to exchange. If an investor has been performing continuous 1031 exchanges to defer capital gains taxes, completing a 721 exchange will end the cycle. By contributing a property to an UPREIT, the investor will still defer their taxes, but they will no longer own the property and can’t perform 1031 exchanges with it going forward.
How to Get Started in 721 Exchanges
One way to perform a 721 exchange is to perform one with a DST that has a preset 721 option. After a typical holding period for a DST, the sponsor arranges to contribute the DST property or properties to a REIT to perform a 721 exchange. The investor’s interest is then converted into units in the operating partnership.
Before an investor performs a 721 exchange, they should consult a tax advisor to determine whether the exchange is right for them. It’s also crucial to have the help of investment advisors who can walk through the details of the investment and ensure each step is performed correctly to meet the investor’s investment goals.
Invest with Confidence
721 exchanges can be an attractive investment option for investors, whether they want to defer capital gains tax or diversify their portfolio. These exchanges can also be an alternative to 1031 exchanges that enables greater timeline flexibility. Although every investment carries a degree of risk, 721 exchanges can offer several benefits for investors.
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