Investors who want to defer capital gains taxes while diversifying their real estate portfolio can consider a 721 exchange. Section 721 of the Internal Revenue Code permits an investor to swap investment or business property for shares in a Real Estate Investment Trust (REIT) without triggering a taxable event. The transaction enables investors to boost the liquidity and diversification of their real estate investments while delaying the hefty capital gains and depreciation recapture taxes that would otherwise be incurred upon selling a property.
Many REITs use IRC Section 721 to acquire property from investors who want to sell their investment real estate but want to avoid finding a replacement property as part of a 1031 tax deferred exchange or paying capital gains taxes. Rather than trading one real estate property for another, an investor might use section 721 to directly contribute to a REIT’s operating partnership (the organization through which the REIT acquires and owns its properties) in a like exchange transaction for operating partnership units.
Advantages of Investing in a 721 Exchange Property
The 721 Exchange is technically a “purchase and sale agreement.” However, rather than receiving dollars as payment, you accept the equivalent amount of Equity in the acquiring firm. Thereby exchanging the equity shares of the relinquishing ownership company for the equity shares of the acquiring company.
In a standard property sale, the seller would pay taxes on the realized capital gains and the depreciation used to defer taxes on the property’s income. Capital gains and depreciation recapture taxes may surpass 20-30% of realized gains, leaving the investor with less money for reinvestment.
A 721 exchange allows investors to avoid taxes while keeping their wealth working by exchanging investment property for shares in a REIT. REITs are obligated to distribute 90% of their taxable income to shareholders in the form of distributions. The REIT declares distributions annually and usually distributes them monthly or quarterly.
In a REIT structure, the 721 exchange allows an investor to diversify across geography, industry, tenant, and asset class. As a REIT shareholder, the individual investor invests in a diverse real estate portfolio and is no longer concentrated and reliant on a single asset for income flow and gain.
REITs can also give the same continuous benefits of real estate ownership, such as income, tax depreciation, principal pay down, and appreciation. Many REITs are still making acquisitions regularly. This permits the investor to benefit from future REIT acquisition possibilities without incurring any capital gains or depreciation recapture tax consequences.
Individual investors can use the 721 exchange to trade an actively managed real estate asset for a portfolio of actively managed real estate assets managed by the principals of a Real Estate Investment Trust. REITs enable ordinary investors to get access to and rely on the expertise of institutional asset management firms for all real estate portfolio choices. REITs are passive investments structured to offer acquisitions, property management, dispositions, investor communication, and the distribution of portfolio income to investors.
When physical real estate and other real properties are passed down to a next of kin, they can cause complications. A 721 exchange allows you to convert your real estate into stable REIT shares. Your heirs can then easily split, hold, or liquidate the shares. You will also benefit from distributions paid to you while you are alive, along with the REIT’s capital appreciation. Furthermore, because the shares are passed through a trust, your heirs will be exempt from capital gains and depreciation recapture taxes, providing a full step-up in basis.
Using an umbrella partnership real estate 721 exchange to defer capital gains taxes is a wise decision. It has several advantages, such as investment diversity, consistent cash flow, and simplicity of asset transfer. A 721 exchange, on the other hand, is quite rigid. Loss and gain are linked to the management of a REIT over which you normally have little control. Overall, when deciding which tax deferment plan to use, it is critical to weigh the advantages and disadvantages properly.
The best way for the typical real estate investor to accomplish a 721 exchange is not to have a major REIT come in and buy your property but to 1031 exchange into a Delaware Statutory Trust (DST) and have that property UPREIT into a major REIT.
So, is investing in a 721 Exchange Property the right decision for you?