The Benefits Of Investing In 721 Exchange Properties For Passive Income
Real estate investors who want to defer capital gains taxes while diversifying their holdings might consider using a IRC Section 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) or an Operating Partnership without triggering a taxable event.
The transaction allows investors to increase the liquidity and diversification of their real estate interests while postponing the relatively expensive capital gains and depreciation recapture taxes that may occur from property sales.
While many of our articles speak to the advantages and disadvantages of an investment, this one only talks about the advantages.
What Is Section 721 Exchange?
A 721 exchange is also known as an UPREIT (Umbrella Partnership Real Estate Investment Trust). These laws allow a taxpayer to exchange business or investment property for REIT shares. An REIT is a form of investment firm that buys and sells commercial real estate.
Rather than selling the property, the owner exchanges it for Umbrella or Operating Partnership (OP) units, which can then be turned into REIT shares or cash. Although OP units and REIT shares are substantially and economically equivalent, and the REIT pays distributions to both, only REIT shares can be liquidated.
How Does It Work?
After holding a 1031-exchange replacement property for about 24 months, the owner can then undertake a 721 exchange. At this point, the property is contributed to a REIT in exchange for its value in Operating Partnership (OP) units, without having to pay capital gains taxes on the sale and depreciation of commercial property.
After one year, the investor may convert the OP units into REIT shares or cash. This conversion, however, is a taxable event if conducted within the owner’s lifetime. After the owner’s death, the heirs can convert the OP units to REIT shares or cash at current market value without paying capital gains taxes. This estate planning technique provides those heirs with a step-up in cost basis and allows them to receive the proceeds quickly and let them do what they’d like at that time.
The Benefits Of The Section 721 Exchange
In a normal property sale, the seller would pay taxes on both the realized capital gains and the depreciation used to defer taxes on the property’s income. Capital gains and depreciation recapture taxes could amount to 20-40% of the gains realized upon sale, leaving the investor with less capital for reinvestment. A Section 721 Exchange allows investors to avoid taxes and keep their wealth working for them by exchanging investment property for shares in an Operating Partnership in a tax-deferred exchange.
In an Operating Partnership structure, the 721 Exchange allows an investor to diversify across geography, industry, tenant, and asset class. As a shareholder in the Operating Partnership, the individual investor gains access to a diverse portfolio of real estate and is no longer reliant on a single asset for cash flow and appreciation. The Operating Partnership can give the same continuous benefits as real estate ownership, such as income, tax depreciation, principal pay down, and appreciation.
The Operating Partnership can continue to make purchases in the future. This permits the investor to take advantage of future buying opportunities in the Operating Partnership without incurring any capital gains or depreciation recapture tax consequences.
Other Benefits of Investing in 721 Exchange Properties As An Investor
- Consistent Income: Operating Partnerships can pay out dividends or distributions to investors in the same way they did when they owned the donated property.
- Tax Deferral: Contributing property or cash from the sale of real estate into the Operating Partnership defers any taxable income from the sale/transfer of the underlying real estate.
- Tax Protection on the Sale of a Portfolio Asset: When an Operating Partnership property is sold, partnership accounting and management fees create enough expenses to offset any gains awarded to investors, but a lockout period and indemnification clause generally offset the risk of gains.
- Portfolio Diversification: The investor owns a stake in an ongoing Operating Partnership that includes a diverse portfolio of real estate developments.
- Passive: The Section 721 Exchange permits investors to exchange an actively managed real estate asset for a portfolio of real estate assets actively managed by the partners of an Operating Partnership whose operations are focused on real estate development, investment, and mortgages. This framework enables private investors to access and rely on the expertise provided by institutional asset management firms for all real estate portfolio decisions. The Operating Partnerships are passive investments that are organized to provide acquisitions, property management, dispositions, investor communication, and distribution of portfolio income to investors.
Considering Investing in 721 Exchange Property?
Before implementing a 721 exchange, the details and qualifications should be thoroughly considered. If an investor uses a 721 exchange, it’s crucial to remember that REIT shares are not qualified for a 1031 exchange. Therefore, the only options are reinvestment or liquidation. In terms of tax-deferred exchanges, a 721 exchange ends an asset’s lifeline.
Furthermore, estate inheritance is a common use of a 721 exchange because liquidation during the original owner’s lifetime is a taxable event. Before completing a 721 exchange, consider the current value of the REIT’s shares. If the shares are expensive, investors may lose money as the market corrects.
At Sera Capital, we understand the workings and benefits of investing in 721 Exchange properties. That is why as an investment group, we offer our clients the opportunity to take advantage of these strategies, especially when it aligns with their goals.
Sera Capital is a wealth management consulting firm specializing in all aspects and all available tax-efficient exit options for business owners, real estate investors, and developers. Our team works with you and your advisors to examine all available solutions, including 1031 Exchanges, Delaware Statutory Trusts, 721 UPREITS, Opportunity Zone Funds, and Section 453 Installment Sales, including Deferred Sales Trusts and Structured Installment Sales. We have two mottos. The first is “We help landlords and business owners exit tax efficiently,” and our second is “When you want out, call us in.”