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Everything You Should Know About 721 Exchanges (UPREITs)

What Is a 721 Exchange (UPREIT)?

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Investors have many investment vehicles available to them depending on their investment goals and financial situation. 721 exchanges are a lesser-known 1031 exchange alternative, yet these exchanges offer numerous benefits.

A 721 exchange is a type of real estate exchange that allows investors to contribute property to an umbrella partnership real estate investment trust (UPREIT) in exchange for units of equity interest in the operating partnership of the REIT. These exchanges allow investors to defer capital gains taxes from selling their property and receive dividends from the UPREIT. Investors should understand the details of performing a 721 exchange to decide whether the transaction might be right for them.

What Is an UPREIT?

What Is a 721 Exchange (UPREIT)?

A 721 exchange is an exchange of real estate property for units in an operating partnership (OP). The units can then be converted into shares in a real estate investment trust (REIT). The property being sold cannot be personal property and must be held for investment or business purposes to qualify for a 721 exchange. The Internal Revenue Service (IRS) describes these exchanges in Section 721 of the Internal Revenue Code (IRC).

A 721 exchange is an exchange of real estate property units in an operating partnership (OP).

A section 721 exchange allows investors to defer capital gains taxes, which can otherwise significantly reduce the profits of a real estate property sale. Other benefits include diversifying the investor’s portfolio and obtaining access to professional management and liquidity.

A 721 exchange only triggers a taxable event when the investor redeems their shares, which they can do all at once or over time. Redeeming over time may allow the investor to take advantage of more favorable tax rates if they are in a lower tax bracket. Investors can earn steady dividend income from their units in the UPREIT and may benefit from several other advantages of 721 exchanges.

Difference Between a 721 Exchange and a 1031 Exchange

Like a 721 exchange, a 1031 exchange allows investors to defer capital gains taxes when relinquishing control of an investment property. While 1031 exchanges and 721 exchanges are similar, there are several significant differences between these types of transactions. Here are two main distinctions to note when comparing a 721 exchange vs. a 1031 exchange:

  • Types of assets being exchanged: In a 721 exchange, the investor relinquishes control of a real estate property in exchange for units of equity interest in the operating partnership. Investors must perform 1031 exchanges with like-kind real estate properties. A 721 exchange would not satisfy the requirements for a 1031 exchange because the units of equity interest are not of the same character or nature as the real estate property. More details of this distinction are addressed below.
  • Timeline: Investors in 721 exchanges don’t have to follow a specific timeline. However, investors must perform the 1031 exchange process within a strict deadline. After selling their relinquished property, investors have 45 days to identify replacement properties for their exchange and 180 days from the date of the sale to purchase a property.

The main two distinctions to note when comparing 721 exchanges and 1031 exchanges are types of assets being exchanged and timeline.

How Does a 721 Exchange Work?

IRC Section 721 states that if a property is contributed to a partnership in exchange for an interest in the partnership, no gain or loss will be recognized from the exchange. A 721 exchange does not trigger a taxable event, and the IRS will not collect taxes on any realized capital gains from the property sale.

The 721 exchange process typically follows these steps:

  • The investor contributes their relinquished property to the umbrella partnership, also called the operating partnership (OP), of an UPREIT.
  • The property contributor receives units of interest in the umbrella partnership and becomes a unitholder.
  • The OP maintains ownership of the properties and distributes the income to the unitholders. 
  • OP unitholders may choose to exchange OP units for REIT shares, which could be more easily sold. 

To understand how this transaction works, you must first understand an UPREIT structure.

What Is an UPREIT?

An UPREIT allows investors to exchange their properties for units in the UPREIT. Generally, any REIT that allows property-for-share exchanges under IRC Section 721 can be considered an UPREIT. UPREITs managers handle the administration and management of the properties within the REIT’s portfolio to generate revenue. The UPREIT then distributes income to unitholders. If a unitholder liquidates their units or converts their units to REIT shares, it creates a taxable event.

An UPREIT allows investors to exchange their properties for units in the UPREIT.

What Is a DownREIT?

A DownREIT is a REIT alternative developed from UPREITs that also allows investors to contribute property in exchange for units in the operating partnership. The difference between an UPREIT vs. a DownREIT is that a DownREIT allows investors to become partners in a limited partnership agreement with a REIT instead of operating under an umbrella partnership.

An investor may choose a DownREIT because they believe the value of their property will appreciate more than the REIT-owned properties. Rather than exchanging properties for units in the operating partnership, a real estate investor contributes their real estate to the operating partnership in exchange for units in the operating partnership. The operating partnership then leases the property to the REIT, which operates the property and pays rent to the operating partnership. The investor receives a portion of the rental income in proportion to their units in the operating partnership.

Another distinction between a DownREIT and UPREIT is that DownREITs may not have the same tax advantages as UPREITs if the investor fails to structure the transaction properly.

What Are the Primary Benefits of a 721 Exchange?

What Are the Primary Benefits of a 721 Exchange?

A 721 tax-deferred exchange can provide investors with several unique benefits. Understanding potential 721 exchange pros and cons can help you decide whether this transaction fits your investment goals. The advantages of a 721 exchange can vary depending on the specific structure and agreements in place. Consider the potential benefits of performing a 721 transaction:

When a real estate investor is the direct owner of a property used for investment or business purposes, they must typically take an active role in managing that property. Even when they hire a property manager to oversee administrative duties, the investor is still ultimately in control of decision-making regarding their investment. In addition, if rental income from a property fluctuates due to market conditions, the investor must absorb any losses.

With a 721 exchange, the investor is no longer the direct owner of their property but becomes an UPREIT unitholder. This position relieves investors of the managerial duties associated with property management. Instead, the UPREIT manager oversees the portfolio of assets and distributes income to unitholders, making 721 exchanges an opportunity for investors to earn passive income from the properties.

Another significant benefit of performing a 721 transaction is the tax advantages. A typical sale of real estate property is a taxable event. The IRS will collect taxes on capital gains and depreciation recapture, which can significantly reduce the profits from the sale. If investors want to reinvest their profits, triggering a taxable event can reduce their purchasing power.

A 721 exchange doesn’t trigger a taxable event. These exchanges are tax-deferred because the investor only realizes the gains from the property sale when they liquidate their units in the operating partnership.

An investor can trigger a taxable event by selling their units in the operating partnership or converting them into REIT shares. If the 721 exchange REIT sells the contributed property and returns the capital gains to investors, that could also trigger a taxable event.

Increased liquidity in an investment can be a significant advantage for investors who want to sell their investments for cash. The more liquid an investment, the easier and faster it is for the investor to sell the asset for cash.

Real estate is typically considered an illiquid investment. Real estate properties are often financed, and it may take a while for buyers to obtain the financing they need. Depending on market conditions and the type of property being sold, sellers may have difficulty finding a buyer, so their assets are tied up in the property longer. There are also time-consuming processes like appraisals and inspections that may occur before a sale can be finalized.

A 721 exchange allows investors to increase the liquidity of their real estate investment by exchanging the property for units in an operating partnership. Those units can then be converted into REIT shares and sold fairly easily. Publicly traded REIT shares can be bought and sold on public exchanges, making it easier for investors to monetize their investments and reallocate their capital as their needs and goals evolve. Public non-listed and private REIT shares are less liquid than publicly traded REITs.

Many investors diversify their portfolios to benefit from multiple asset classes and manage their risk. Portfolio diversification can provide benefits like reducing the impact of market fluctuations on your investments, gaining revenue from multiple sources, and combining levels of risk from different investments.

Since a 721 exchange allows investors to acquire units in the operating partnership of a REIT, they can benefit from the diversification these investments can provide. REITs may hold assets across multiple geographic regions, industries, or asset classes. Some equity REITs focus on specific assets belonging to the same sector, such as healthcare REITs or self-storage REITs. Others diversify with a range of real estate properties across sectors and industries. These characteristics make many REITs a more diversified investment than owning real estate properties outright. Investors no longer have their assets tied up in one property but gain access to all the properties in the REIT’s portfolio.

721 exchanges may also simplify estate planning for some investors. Investors can use the 721 transaction to prepare to pass their assets to their heirs. Real estate properties may be difficult to pass to heirs because of challenges in selling the property or conflicts regarding how to split the asset. These problems can create estate problems for the heirs.

A 721 exchange lets an investor easily pass their investment on to their heirs. Upon the investor’s death, they can convert their units to REIT shares and split their shares in the REIT equally between their heirs. These shares are easier to liquidate than physical real estate properties. The heirs will also receive a step-up in basis, meaning the starting value that determines what taxes are owed becomes the fair market value on the date of the investor’s death rather than the original purchase price. The heirs can hold their shares in the REIT and continue receiving dividends or liquidate them for cash. 

What Are the Potential Disadvantages of a 721 Exchange?

What Are the Potential Disadvantages of a 721 Exchange?

Although 721 exchanges can provide investors with some significant advantages, there may also be some cons. Consider some of the potential drawbacks of performing a 721 exchange:

721 exchanges are passive investments. Operating partnership unitholders are not directly involved in managing properties within the REIT’s portfolio. Investors who want a more active role in their investments may not prefer 721 exchanges. However, the REIT manager updates unitholders on acquisitions, distributions, and dispositions.

While investors have complete control over when they convert their units in the operating partnership into shares or liquidate their shares in the REIT, they don’t have control over when the REIT sells their contributed property. This action could trigger a taxable event that the investor wasn’t prepared to handle yet.

A significant downside of 721 exchanges is the inability to perform a 1031 exchange with the property later. When an investor exchanges the property for units of equity interest in an operating partnership, the investor no longer owns the property and can’t use it in a 1031 exchange. Additionally, the OP units are also not eligible for a 1031 exchange.

What Situations Would be Appropriate for Considering a 721 Exchange?

Investors in various situations could decide to complete a 721 exchange. Here are a few instances where an investor could consider a 721 exchange:

  • They have surplus property generated by consolidations.
  • They want to defer taxes when selling real estate. 
  • They prefer to avoid property management responsibilities. 
  • They want to diversify their assets by exchanging a single property for interest in a portfolio. 
  • They want to receive consistent passive investment income.

What Is a Good 721 Exchange Candidate Property?

In rare cases, UPREITs may identify properties they consider ideal for a 721 exchange. The following properties could be good choices for this type of exchange:

  • A property with a third-party tenant.
  • Properties that meet the REIT investment criteria, which can vary.

Can You Combine a 1031 Exchange With a 721 Exchange?

Investors can sometimes combine a 1031 exchange with a 721 exchange to ensure the property they want to contribute to the operating partnership meets the acquisition criteria of the REIT they want to invest in. This strategy can be used when the property an investor owns doesn’t align with the REIT’s requirements.

Investors can sometimes combine a 1031 exchange with a 721 exchange to ensure the property they wat to contribute to the operating partnership meets the acquisition criteria of the REIT they want to invest in.

In some cases, the investor may decide to perform a 1031 exchange to acquire a property that does meet the REIT’s criteria. The investor must then demonstrate their intent to hold the property for business or investment use to IRS. There is no requirement for how long to hold the property, but many investors choose to hold it for 12 to 24 months. After that time, they can contribute the 1031 exchange property to the REIT in exchange for units in the operating partnership.

Investors can also complete a 721 exchange with a Delaware Statutory Trust (DST) property to acquire a fractional interest in property that meets the criteria of the REIT. This process begins with the investor investing in a DST that has a 721 option and acquiring fractional ownership in an institutional-grade property. After a sufficient holding period, the sponsor would contribute the property to the REIT in exchange for OP units. This is becoming a more common option with DST sponsors as an added benefit to investors. 

Can You Perform a 1031 Exchange After a 721 Exchange?

Investors cannot use units in a UPREIT to complete a 1031 exchange. 1031 exchanges can be made indefinitely as long as the investor owns the property they want to exchange. If an investor has been performing continuous 1031 exchanges to defer capital gains taxes, completing a 721 exchange will end the cycle. By contributing a property to an UPREIT, the investor will still defer their taxes, but they will no longer own the property and can’t perform 1031 exchanges with it going forward.

If an investor has been performing continuous 1031 exchanges to defer capital gains taxes, completing a 721 exchange will end the cycle.

How to Get Started in 721 Exchanges

There are a couple of ways to perform a 721 exchange. The first method involves the investor selling their relinquished property and structuring the sale as a 1031 exchange. However, instead of finding a replacement property, the investor identifies and acquires real estate the REIT has selected. After a holding period of between 12 and 24 months, the investor contributes their fractional interest to the operating partnership as part of the 721 exchange. In exchange for the contributed property, the investor receives an interest in the operating partnership.

Another potentially easier way to perform a 721 exchange is to perform one with a DST that has a preset 721 option. After a typical holding period for a DST, the sponsor arranges to contribute the DST property or properties to a REIT to perform a 721 exchange. The investor’s interest is then converted into units in the operating partnership.

Before an investor performs a 721 exchange, they should consult a tax advisor to determine whether the exchange is right for them. It’s also crucial to have the help of investment advisors who can walk through the details of the investment and ensure each step is performed correctly to meet the investor’s investment goals.

1031 Crowdfunding is a real estate investment platform for 1031 exchanges and alternative investments focused on tax deferral.

1031 Crowdfunding is a real estate investment platform for 1031 exchanges and alternative investments focused on tax deferral. The platform provides the information and documents needed for investors to perform their due diligence, and our expert representatives will walk you through investments with 721 exchange options. To view all our offerings, register for an investor account.

Invest With Confidence at 1031 Crowdfunding

721 exchanges can be an attractive investment option for investors, whether they want to defer capital gains tax or diversify their portfolio. These exchanges can also be an alternative to 1031 exchanges that enables greater timeline flexibility. Although every investment carries a degree of risk, 721 exchanges can offer several benefits for investors.

With a combined $2.2 billion in real estate transactions, the management team at 1031 Crowdfunding has the experience to help investors navigate 721 exchanges and other alternative investments. Our knowledgeable professionals are ready to answer any questions you have and help you invest with confidence.

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This material does not constitute an offer to sell or a solicitation of an offer to buy any security. An offer can only be made by a prospectus that contains more complete information on risks, management fees and other expenses. This literature must be accompanied by, and read in conjunction with, a prospectus or private placement memorandum to fully understand the implications and risks of the offering of securities to which it relates. As with all investing, investing in private placements is speculative in nature and involves a degree of risk, including loss of your principal. Past performance is not necessarily indicative of future results and forward-looking statements and projections are not guaranteed to achieve the results described and your actual returns may vary significantly. Investments in private placements are illiquid in nature and there may be no secondary market or ability to sell the investment should the need for liquidity arise. This material should not be construed as tax advice and you should consult with your tax advisor as individual tax situations will vary. Securities offered through Capulent, LLC Member FINRA, SIPC.

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