In our last blog post, we discussed the mechanics of the 721 (UPREIT) exchange and explained how this process can be used to convert direct property holdings into real estate investment trust (REIT) shares while also deferring capital gains taxes and depreciation recapture. Today, we’ll discuss some of the potential benefits of engaging in a 721 exchange and a few possible drawbacks to consider. Once you have weighed these pros and cons, you’ll be in a better position to determine whether a 721 exchange may benefit you.
Direct property ownership often means that a significant portion of an investor’s portfolio is tied-up in a single asset. Since larger REITs tend to hold multiple properties in a variety of locations with an aggregate value often exceeding several hundred million dollars, they can provide greater diversification when compared to holding a single physical property or a smaller Delaware Statutory Trust (DST).
REITs can also reduce concentration risk by providing exposure to property investments in multiple regions and, in some cases, across several industries
When you engage in a two-step 721 exchange, the proceeds from the sale of a relinquished property are initially used to purchase DST interests. Then, later, the REIT acquires the DST in exchange for operating partnership units (OP units)1.
Once the process is completed, OP Units can typically be converted into REIT shares. If the REIT is publicly traded, REIT shares are bought and sold on the open market thereby providing liquidity options to the investor. If the REIT is private, the REIT sponsor may provide redemption options whereby investors may sell their shares back to the REIT – typically each quarter. These options can provide greater liquidity than a direct property holding or an investment in a DST. However, it should be noted that the conversion of REIT operating into REIT shares prior to a planned sale can create a taxable event and eliminate the ability to defer capital gains on the assets in the future.
When completed correctly, a 721 exchange allows you to defer your capital gains taxes and depreciation recapture, so you can invest the entire proceeds from the sale of an investment property into your new REIT shares. In addition, REIT shares that provide liquidity options could be advantageous to investors who want to spread out their tax liability over multiple tax years. Depreciation and other tax advantages may apply as well.
Upon the passing of an investor owning REIT shares, their heirs or surviving spouse may inherit those shares at a value determined at time of the passing and potentially avoid capital gains taxes.
While completing a two-step 721 exchange, it’s common to receive income from the DST during the holding period. When the exchange is completed, distributions generated by the OP units can also provide an income stream.
While rental income from direct property ownership may fluctuate due to a variety of factors, REITs typically provide consistent quarterly or annual dividends. The income is also passive, allowing you to avoid the administration, maintenance, and other hassles that are often associated with property ownership. Income received from REITs may also be partially tax sheltered.
Much like a DST, REITs do not allow shareholders to influence management decisions or have any input into the day-to-day operations. Investors coming from direct property ownership may be put off by this lack of control.
Some REITs have higher fees and expenses than you’ll find with a DST or direct property ownership. Before engaging in a 721 exchange, it’s advisable to weigh the costs against the potential benefits to ensure it makes financial sense.
When you convert your OP Units to REIT shares, you’re required to recognize your capital gains, recapture depreciation, and pay any applicable state taxes - even if you do not sell the shares. This may require you to have additional cash set aside to meet your tax obligations.
Once you complete a 721 exchange, you may not complete another tax-deferred exchange out of the OP Units or REIT shares. Since you won’t be able to exit a 721 REIT investment without potentially creating a taxable gain, you’ll want to make sure you’re comfortable with the REIT you have selected. Unfortunately, your choice of REITs is also limited to the ones that are offering OP Units in exchange for the DST you currently own. This can significantly limit your investment options.
After carefully considering the potential pros and cons of engaging in a 721 exchange, you may still wonder whether this is the right option for you. If you would like to explore the idea in greater detail and discuss how it may impact your personal financial situation, the team at First Guardian Group is here to help. Contact us today to schedule a consultation with a member of our team.
1The minimum holding period for DST interests prior to a 721 transaction is typically two years.