What is a 721 Exchange?

What Is a 721 Exchange?

A 721 exchange, also called a "like-kind" exchange under Section 721 of the tax code, lets you swap property for shares in a real estate partnership without paying taxes right away.

 

Real estate investors are familiar with the 1031 exchange, which allows deferral of capital gains taxes by reinvesting sale proceeds into a "like-kind property."

Another provision in the U.S. tax code offers similar tax deferral benefits with added diversification and simpler estate planning: the 721 exchange. Instead of reinvesting sale proceeds into another property, investors can defer taxes by contributing their property to a partnership in exchange for interests in the partnership. Typically, this involves an "UPREIT" structure, where the partnership is a subsidiary of a real estate investment trust (REIT).

"The 721 structure seems to be a very appealing solution for investors who own real estate, and a lot of them don't know that it's an option," said Rich Williams, director at Hines Securities.

While it may sound simple, completing a 721 exchange requires several steps and can take at least two years. Here's more about these opportunities.

What is an UPREIT?

An Umbrella Partnership Real Estate Investment Trust (UPREIT) allows property owners to contribute their property to an operating partnership in exchange for units in the partnership. This structure enables property owners to defer capital gains taxes while converting real estate holdings into a diversified portfolio managed by a Real Estate Investment Trust (REIT). UPREITs handle property management and generate income for unitholders through dividends.

Situations Appropriate for 721 Exchanges

Avoiding Property Management Responsibilities

Investors looking to step back from the day-to-day management of their properties can benefit from a 721 exchange. By converting their real estate holdings into shares of a REIT, they transfer the management responsibilities to professional REIT managers. This can be especially attractive for those nearing retirement or who no longer wish to handle the complexities of property management.

Deferring Taxes

A 721 exchange allows investors to defer capital gains taxes that would otherwise be due upon the sale of their property. This deferral can be especially beneficial in high-tax environments or for investors looking to maximize their reinvestment capital.

Desiring Portfolio Diversification

Investors who want to diversify their real estate holdings across multiple asset classes and geographic locations can use a 721 exchange. By converting their single property into REIT shares, they gain exposure to a broader portfolio managed by the REIT, thus spreading risk.

Planning for Estate Transfer

721 exchanges can simplify estate planning. REIT shares are easier to divide among heirs compared to physical properties. Additionally, heirs receive a step-up in cost basis for the inherited shares, potentially reducing the capital gains tax burden when they decide to sell.

Seeking Passive Income

Investors looking for regular income without the hassles of property management can benefit from the distributions paid out by REITs. These can provide a steady income stream, similar to rental income but without the need for active involvement.

Who Is Eligible for a 721 Exchange?

Accredited investors, who according to the Securities and Exchange Commission have a net worth of at least $1 million, excluding their primary residence; or an income of at least $200,000 individually or $300,000 in combination with their spouse or partner in each of the prior two years, with reasonable expectations of the same for the current year.

How Do 721 Exchanges Work?

For non-institutional investors, a 721 exchange often involves a two-step process since most REITs aren't interested in individual properties from independent investors.

Instead of selling directly to a REIT, investors can sell their property to another buyer and then invest the proceeds in a Delaware Statutory Trust (DST) via a 1031 exchange. The DST pools investors' funds to acquire large, institutional-grade properties. Once the DST raises enough funds, a two-year holding period begins.

During these two years, DST investors typically earn conservative distributions. After this period, a REIT can acquire the DST's property, allowing investors to exchange their DST interests for operating partnership units, which may offer cash distributions and potential value appreciation.

"Assuming the REIT exercises its option to acquire the property, it may potentially give investors diversification benefits while continuing their tax deferral," Williams said.

721 Exchange Process

1. Property Identification and Preparation

   Identify the property for the exchange, ensuring it qualifies for investment or business purposes. Prepare necessary documentation, including appraisals and financial statements.

2. Engage Key Professionals

   Consult with a financial advisor, CPA, and a qualified intermediary to ensure compliance with IRS regulations and proper execution.

3. Find a Suitable REIT

   Locate a REIT that aligns with your goals and accepts 721 exchanges.

4. Negotiate Terms with the REIT

   Agree on the property value and the number of operating partnership units (OP units) you will receive in exchange.

5. Contribute Property to the UPREIT

   Transfer property ownership to the REIT's operating partnership by signing a contribution agreement and transferring the deed.

6. Receive Operating Partnership Units

   Receive OP units in the UPREIT, representing your ownership interest.

7. Holding Period

   Hold the OP units for a minimum of 12 to 24 months, receiving distributions based on the REIT's performance.

8. Conversion to REIT Shares (Optional)

   After the holding period, you can convert your OP units into REIT shares for greater liquidity.

In-Depth Explanation of Property Contribution to UPREITs

Contributing property to an UPREIT means trading your real estate for a share in a larger, professionally managed portfolio. The process starts with the REIT evaluating your property to ensure it meets their criteria. Once terms are agreed upon, you transfer the property's deed to the REIT's operating partnership, documented through a contribution agreement. This agreement outlines the specifics of the exchange, including the number of OP units you'll receive. The REIT then manages the property, and you become a unitholder in the partnership, entitled to a share of the income generated by the REIT's properties. This income is distributed as regular payments, often quarterly, providing a steady stream of passive income. After the required holding period, you may choose to convert your OP units into REIT shares, offering additional flexibility and liquidity.

The Potential Benefits of a 721 Exchange

There are several potential benefits to a 721 exchange, as an alternative, or as a complementary solution to a 1031 exchange:

• Diversification. Unlike a 1031 exchange, when you are exchanging a single property for another, REITs can hold properties across several different asset classes, or at least across a wide geographic footprint within a single asset class.
• Liquidity. There is a two-year holding period in the DST as required by the IRS. When an investor sells their interest in the operating partnership or the REIT for liquidity, it likely triggers a taxable liability. Additionally, if operating partnership units are exchanged for REIT shares instead of cash, note that some REIT shares are not publicly traded, which can limit liquidity. Despite this, operating partnership units and REIT shares can still provide passive income for 721 investors, with modest cash distributions possible during the two-year holding period. Selling shares in a REIT is also generally easier than selling a property.
• Tax Deferral. A 721 exchange allows investors to defer capital gains taxes that would otherwise be owed following a conventional real estate sale.
• Simple Estate Planning. One property may be difficult to sell or divide interests in when passing assets on to multiple heirs. REIT and operating partnership interests, however, can easily be split and either held or sold by beneficiaries in a decedent's trust. Deferred capital gains cannot be inherited, so heirs will receive a step-up in cost basis in their shares, and only pay capital gains when they sell shares for a gain, not when they inherit.

"It is an extremely powerful estate planning and generational wealth transfer solution for a lot of investment property owners," Williams said.

Drawbacks to a 721 Exchange

• Fees. 721 investors need to find a qualified intermediary and invest through a financial advisor, both of which will charge a fee. Then, there is the management fee the REIT charges, which usually ranges from 1 to 2 percent of equity invested.
• Time. As noted above, there will be a minimum two-year holding period within the DST, during which time investors generally could expect to earn only modest cash distributions relative to the returns they might realize during that period if they had sold the property via a 1031 exchange or sold the property and invested the sale proceeds in more lucrative investment opportunities. There is also the risk that the property held in the DST falters during this period.
• Limited Future Options. Unlike in a 1031 exchange, where an investor can keep swapping like-kind properties, a 721 investor cannot sell their operating partnership units to the REIT to get liquidity in their lifetime without incurring capital gains taxes on their original sale. This makes 721 exchanges most appealing as an estate planning tool.

"In a standalone 1031 exchange, the investment is in the single property, and once that property is sold, then the investor has the option to do another 1031 exchange, and you could essentially "swap till you drop," as it's referred to. With the 721, that's not the case," Williams said. "If the 721 is exercised investors can't go from the diversified portfolio back into a single asset. The portfolio that they're investing into is the last stop until the client either decides to liquidate their position or hold until passing."

Comparison Between 1031 Exchange and 721 Exchange

Differences in Asset Types Exchanged

• 1031 Exchange: Involves the exchange of like-kind real estate properties. The properties must be of the same nature or character but not necessarily of the same quality. For instance, you can exchange a commercial building for a farmland, as long as both are held for investment or business purposes.
• 721 Exchange: Involves exchanging real estate property for units in an operating partnership (OP) of a real estate investment trust (REIT). The exchanged property must be used for investment or business purposes, but it converts into equity shares in the REIT's partnership, not another physical property.

Timelines and Deadlines Involved

• 1031 Exchange: Strict deadlines must be adhered to. The investor has 45 days from the sale of the relinquished property to identify potential replacement properties and 180 days from the sale to complete the purchase of the replacement property.
• 721 Exchange: No specific IRS-mandated timelines. However, the process generally involves a two-step approach where the property is first placed into a Delaware Statutory Trust (DST) for at least two years before converting DST interests into REIT partnership units. This flexible timeline can be more accommodating for investors.

Who Should Investors Contact?

There are a few key professionals an interested investor should contact to start a 721 exchange:

• Financial Adviser. In most cases, a financial adviser will find 721 exchange opportunities for the investor.
• Certified Public Accountant or Tax Adviser. With this being a tax strategy, it's paramount to have a CPA or other tax adviser involved to make sure the process is done correctly.
• Qualified Intermediary. Investors should contact the qualified intermediary before selling their original property so that the proceeds roll directly to the intermediary. If proceeds from the sale hit the investor's bank account, the sale becomes a taxable event.

This article was updated on 7/29/2024