For real estate investors seeking to grow their wealth while minimizing tax liability, the 721 exchange is a powerful but often overlooked strategy. This tax-deferred approach allows property owners to contribute real estate to a Real Estate Investment Trust, or REIT, through an UPREIT structure in exchange for operating partnership units, abbreviated as OP units. In this guide, weāll break down the essentials of a 721 exchange, how it works, and how it compares to other tax-deferral strategies like the 1031 exchange.
What Is a 721 Exchange?
A 721 exchange is a tax-deferral strategy that allows real estate investors to contribute property to an Umbrella Partnership Real Estate Investment Trust (UPREIT) in exchange for operating partnership units. These units can generate income, appreciate, and be converted into REIT shares in the future, providing potential liquidity.
This exchange structure defers capital gains taxes, making it an attractive option for property owners looking to exit active property management and transition into a more passive investment.
How Does a 721 Exchange Work in Real Estate?
In a 721 exchange, an investor transfers ownership of their real estate asset(s) into the operating partnership of a REIT. In return, they receive OP units equivalent in value to the contributed property.
Hereās how the process typically works:
- Identify a REIT with an UPREIT structure that accepts property contributions.
- Negotiate the value of the property and the number of OP units to be received.
- Transfer the property into the REITās operating partnership.
- Receive OP units, which often entitle the holder to a share of income and potential appreciation.
- After a holding period, OP units can typically be converted into publicly traded REIT shares, offering liquidity.
This structure enables investors to diversify their holdings and benefit from professional real estate management while deferring capital gains taxes.
Understanding IRC Section 721 and Its Tax Benefits
IRC Section 721 of the Internal Revenue Code provides the legal framework for the 721 exchange. It states that no gain or loss is recognized when property is contributed to a partnership in exchange for an interest in that partnership.
This provision allows investors to:
- Defer recognition of capital gains taxes on appreciated property.
- Avoid immediate tax liability while converting real property into a diversified REIT holding.
- Potentially convert OP units into REIT shares in the future for liquidity, triggering taxable events only when sold.
Section 721 plays a crucial role in enabling real estate owners to transfer their property into a REIT without paying taxes upfront.
721 Exchange Rules: Key Requirements and Limitations
While a 721 exchange offers valuable tax deferral opportunities, investors must follow certain rules and meet specific requirements:
- Eligible Assets: Only real property qualifies for a 721 exchange. Personal property is excluded.
- UPREIT Participation: The exchange is facilitated through a REIT that operates as an UPREIT structure.
- Deferred Taxes: Taxes are deferred until OP units are converted into REIT shares and sold.
- Loss of Control: Investors relinquish direct control of their contributed property.
- No Reverse 1031 Exchange: Once a property is contributed through a 721 exchange, it is no longer eligible for a future 1031 exchange.
- Holding Periods: There may be mandatory holding periods before OP units can be converted to REIT shares (often 12 months).
Understanding these rules is essential for investors considering a 721 exchange.
What is a Section 721(c) Partnership?
IRC Section 721(c) deals with partnerships that include foreign partners. It was enacted to prevent U.S. taxpayers from deferring taxes by transferring appreciated property into partnerships with foreign partners.
Key points about Section 721(c):
- It requires immediate recognition of built-in gain on appreciated property transferred to certain partnerships with foreign partners.
- These regulations typically donāt impact domestic REIT structures, unless foreign investors are involved.
- For most standard 721 exchanges involving U.S.-based REITs and domestic investors, Section 721(c) is not a significant concern.
Benefits of a 721 Exchange for Real Estate Investors
A 721 exchange offers several compelling advantages for real estate investors:
- Tax Deferral: Defer capital gains taxes on appreciated property until OP units are converted and sold.
- Diversification: Gain exposure to a professionally managed, diversified REIT portfolio.
- Passive Income: Receive distributions from the REIT without managing the property directly.
- Liquidity Options: Convert OP units into publicly traded REIT shares, offering potential liquidity.
- Estate Planning Benefits: OP units can be transferred to heirs with potential step-up in basis.
These benefits make the 721 exchange an appealing option for investors looking to transition from active property management to a more passive role.
721 Exchange vs. 1031 Exchange: Key Differences
Both the 721 exchange and 1031 exchange allow for deferral of capital gains taxes, but they work differently:
| Feature | 721 Exchange | 1031 Exchange |
| Asset Type | Real estate contributed to an UPREIT | Like-kind real estate exchange |
| Ownership | OP units in REITās operating partnership | Direct ownership of replacement property |
| Management | Passive (REIT-managed) | Active (self-managed or third-party) |
| Liquidity | OP units are convertible to REIT shares | Illiquid real estate ownership |
| Future Exchanges | No future 1031 exchanges after 721 | 1031 exchanges can continue indefinitely |
| Tax Deferral | Deferred until sale of REIT shares | Deferred until sale of replacement property |
The 721 exchange appeals to those who want passive investments and portfolio diversification, while the 1031 exchange works for investors seeking continued direct property ownership and management.
Potential Risks and Considerations of a 721 Exchange
While beneficial, a 721 exchange carries potential risks:
- Loss of Control: Once property is contributed, decisions are made by the REIT, not the investor.
- Liquidity Risk: Although OP units can be converted into REIT shares, there may be restrictions on when and how.
- Taxable Event on Sale: Converting OP units into REIT shares and selling them triggers a taxable event.
- Valuation Risk: OP units are tied to the performance and valuation of the REIT, which can fluctuate.
- Limited Exit Options: Once in the REIT structure, options for exiting without triggering taxes are limited.
Itās important to conduct due diligence and consult with tax and legal advisors before proceeding.
How to Execute a 721 Exchange Successfully
Executing a 721 exchange involves several steps:
- Find a REIT/UPREIT: Identify a REIT that offers an UPREIT structure and accepts property contributions.
- Evaluate the Property: Ensure the propertyās value and characteristics fit the REITās criteria.
- Negotiate Terms: Work with the REIT to determine the value of your OP units.
- Legal and Tax Review: Engage legal and tax professionals to review the transaction structure.
- Transfer Ownership: Execute the transfer of the property to the REITās operating partnership.
- Receive OP Units: Obtain OP units representing your interest in the REIT.
- Monitor Holding Periods: Be aware of conversion restrictions and holding periods.
Proper planning and expert guidance are key to a successful 721 exchange.
Conclusion
The 721 exchange is a powerful tool for real estate investors seeking to defer capital gains taxes, diversify their portfolios, and transition to a passive investment strategy. By contributing property to an UPREIT in exchange for OP units, investors can unlock new opportunities while minimizing immediate tax consequences.
As with any tax strategy, itās crucial to consult with knowledgeable professionals to determine if a 721 exchange aligns with your financial goals. Donāt leave money on the table, contact us at CSSI today!
