For real estate investors, deferring capital gains taxes on property sales can be a key to building wealth. When properties are held for business or investment purposes, engaging in a 721 exchange may allow you to take advantage of a tax deferral by using your property sales proceeds to acquire shares in a Real Estate Investment Trust (REIT). This strategy is commonly used by investors who wish to sell a property and diversify their real estate holdings while also freeing themselves from the time and effort involved in direct property management.
This exchange, also known as an umbrella partnership real estate investment trust (UPREIT), provides investors with the option to defer capital gains taxes without having to adhere to the strict timelines required in a 1031 exchange. Following, you’ll find a closer look at exactly what a 721 exchange is and how it works.
What is a 721 Exchange?
A 721 exchange is like a 1031 exchange, but instead of purchasing a physical replacement property or a Delaware Statutory Trust (DST), you use the sales proceeds from your relinquished property to purchase units in an operating partnership that can eventually be converted into shares of a REIT. This is done by contributing your property directly into the REIT’s operating partnership. Instead of receiving cash for the sale, you receive Operating Partnership Units (OP Units) of the UPREIT. These OP units typically have the same rights as direct shares of the REIT.
After waiting for a designated time period, you can also convert your OP Units into traditional REIT shares. Doing so can give you additional liquidity options, however, it’s important to note that conversion of the OP units to REIT shares is also a taxable transaction. Once you complete the transaction, you cannot defer your capital gains taxes on these shares again and all previously owed taxes will be due, including those that were deferred as a result of prior 1031 exchanges.
2-Step 721 Exchange
While the transaction described above may seem quite simple, it’s rare that an investor holds a property that the REIT actually wants to acquire. In this case, a 721 exchange must be completed using a two-step process.
First, you would begin by selling your relinquished property to a third party and, with the help of FGG1031/First Guardian Group, use the proceeds to purchase shares of a DST. The shares purchased must be in an amount that is equal to the value of the relinquished property and purchased from a DST sponsor who has a REIT that may eventually be interested in purchasing the DST property. The result of this transaction is a successful 1031 exchange, which allows you to defer capital gains taxes and depreciation recapture.
The next step is for the REIT to acquire the DST shares in exchange for OP units. This is the equivalent of contributing an investment property into an UPREIT and results in a successful 721 exchange.
It’s important to note that there are some restrictions. Generally, a two-step 721 transaction should not occur within two years of the initial acquisition of the DST interests. When the initial acquisition occurs, there should also not be any promise or guarantee that a DST 721 transaction will follow.
Case Study
To gain a better perspective of how a 721 exchange works, let’s take a look at a fictional case study.
Assume that two investors jointly own an industrial park. As direct owners, they are responsible for dealing with tenants and handling the property’s maintenance, insurance, utilities, taxes, and any other issues related to the property. They no longer want this responsibility and would like to sell, but due to the property’s low-cost basis, they are concerned about potential capital gains taxes and the financial impact of depreciation recapture.
Instead of selling the property and taking the cash proceeds, the investors contact FGG1031/First Guardian Group to source possible 1031 replacement properties and engage a qualified intermediary in order to use the sales proceeds to purchase interests in a Delaware Statutory Trust (DST). This results in a successful completion of a 1031 exchange.
After two years, the investors exchange their DST interests for OP Units of a REIT, which they believe will provide additional diversification and reliable monthly distributions. By completing this transaction, they have eliminated the burden of direct property ownership. They’ve also potentially mitigated risk by further diversifying their portfolios and deferred their capital gains taxes - all while potentially creating a steady stream of income. By exchanging interests in DST for OP units in a REIT, they also may have potentially created additional liquidity in their portfolios, giving themselves more flexibility.
Some Final Thoughts
While engaging in a 721 exchange can create potentially significant benefits, there are also some potential drawbacks to consider. In the second part of our 721-exchange series, we will explore the pros and cons in greater detail.
Also, keep in mind that UPREIT transactions can be very complex. It’s always important to consult with experienced tax, financial, and legal advisors prior to initiating this type of exchange. To learn more, contact us to schedule a consultation with a member of our team.
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