How To Decide if a 721 Exchange Is Right for You
Carl E. Sera, CMT
March 9, 2023
When investors search for alternatives to defer capital gains taxes without having a strict time frame, 721 exchanges make for an optimal choice. Also known as a UPREIT (umbrella partnership real estate investment trust), this option comes with many benefits and fulfills the needs that 1031 exchanges can’t.
However, is a 721 exchange the best option for your investments? Let’s review how 721 exchanges work, the differences between 1031 and 721 exchanges, the rules, and the various benefits that come with them. With a 721 exchange, you won’t have to think about capital gain taxes.
What Is a 721 Exchange?
721 exchanges follow the IRS code section 721, allowing investors to transfer property held in a like-kind exchange for shares in a Real Estate Investment Trust. Also referred to as a REIT, it which won’t trigger the need to pay capital gains taxes. It’s a mechanism long used by institutional investors, but individual investors are less likely to have familiarity with the concept.
Because it is an IRS-sanctioned process, investors utilize 721 tax deferred exchange to manage cash flow and then reinvest in other properties without needing direct sales taxes. Furthermore, 721 exchanges apply for consolidating multiple properties into a larger singular property. This aspect can help investors with reducing overall investment portfolio sizes.
Differences Between 1031 and 721 Exchanges
So, what are the differences between 1031 and 721 exchanges? Firstly, 1031 exchanges work for real estate investors, helping trade one investment property for another while deferring capital gains tax. Similar to 721 exchanges, the IRC (Internal Revenue Code) Section 1031 requests to find like-kind replacement assets to meet 1031 exchange qualifications. There are fundamental differences between 1031 and 721 exchanges, including ownership, liquidity, income, diversification, and responsibility.
While 721 exchanges take away ownership from investors, 1031 exchanges offer complete decision-making control, making the investor the direct owner. However, 1031s must control maintenance and management as active owners, while 721 removes those burdens. In addition, because 1031s allow investors to own investment properties, they receive regular rental incomes, while 721 exchanges earn passive income.
721 Exchange Rules To Follow
Several rules embedded in the IRS publication 721 require investors to understand how to carry out section 721 exchanges properly. The subcategories include General Rule, Special Rule, Regulations, and Transfers of Intangibles. The General Rule states that no gain or loss shall have recognition to partnerships or any involved partners. This is in cases of a contribution of property to the partnership in exchange for an interest in a partnership.
The Special Rule states that subsection (a) in the Section 721 exchange shall not apply to gain realized on property transfers to partnerships. As such, it would become treated as an investment company if parentship becomes incorporated. Regarding certain transfers to partnership, investors shall not apply to gain on property transfers to a partnership if such gain becomes includible in a person’s gross income. Lastly, the Secretary may provide regulations in the rules of paragraph (2) or Section 367. It applies to the transfer of intangible property by a United States person to a partnership. It is in the circumstances consistent with the purpose of transfers to intangibles.
Benefits of 721 Exchanges
Many benefits come with 721 exchanges. Read on to explore the various benefits that this option brings to the table.
While real estate can typically categorize as an illiquid asset, the asset can become tied up for a substantial amount of time. However, transactions through a 721 exchange allow investors to potentially increase liquidity.
This process converts some or all the OP Units into shares of the REIT. As such, they can then become sold. However, keep in mind that it can create a taxable event.
721 exchanges allow investors to pass their assets to their chosen heirs. Upon death, shares can become split equally and either remain held or liquidated by the trust’s beneficiaries. In addition, because the shares pass through a trust, beneficiaries receive a step-up in bases and defer capital gains taxes and depreciation recapture with little hassle.
When real estate sells, investors pay taxes on capital gains realized, along with depreciation recapture. As a result, this process leaves investors with less capital for their retirement.
Thankfully, 721 exchanges allow investors to defer hefty taxes through a tax-deferred exchange of appreciated real estate for shares in operating partnerships. Share in operating partnerships, also known as OP Units, which converts to REIT shares or contributed property, becomes sold by the acquiring operating partnerships.
Because the 721 UPREIT exchanges allow investors to purchase REIT shares, REIT shareholders don’t have their interests tied up in a single asset. Instead, a REIT generally has properties in different locations, along with possibilities of having industry, asset, and tenant class diversification. Through diversification, this option can help investors manage potential risks.
While property management typically associates with owning a real estate property, REIT shareholders don’t need to worry about it. Managers have responsibility for the portfolio of assets of the REIT and oversee operations. While maintaining control over acquisitions, dispositions, and distributions, investors don’t become involved in other decisions.
Because of the changes in the market, cash flow through rental properties can change, producing less rental income than initially anticipated. Thankfully, REITs typically pay dividends to shareholders.
Are 721 Exchanges Right for Me?
So, is a 721 exchange right for you? With the previously mentioned benefits, rules, and differences between 1031 and 721 exchanges, it can benefit you greatly. However, it can become a complicated process involving several requirements.
Thankfully, speaking to a 721 exchange advisor can help guide you in the right direction and help educate you on successfully deferring capital gains taxes. They can even help with turning a 1031 exchange into a REIT.
Sera Capital specializes in exit planning for clients selling highly appreciated real estate, concentrated stock positions, and businesses. As fiduciaries, we are not beholden to any product sponsor or institution for client solutions. Our 721 exchange advisors allow investors to transfer property held in a like-kind exchange for shares in a REIT without needing to pay capital gains taxes. For more information, reach out to our professionals today at Sera Capital for a free 30-minute phone call.