We talk about 1031 exchanges all day long! But… Did you know that 721 exchanges are another means to defer capital gains when exchanging property?
We also talk about DSTs and TICs as exchange-qualified institutional replacement properties, but… Did you know with 721 exchanges, REITs can become an exchange-qualified alternative institutional option?
Because we want you to understand your options, here are some basic facts about:
721 Exchanges:
• Section 721 of the Internal Revenue Code states that no gain or loss will be recognized when property is contributed to a partnership in exchange for an interest in the partnership.
• A pure 721 exchange would consist of the contribution of property, such as real estate, directly to a partnership, such as the operating partnership of a REIT, in exchange for units of beneficial interest in that partnership.
• The IRS will not seek to collect taxes on capital gains for the sale of a property when it is disposed of through a 721 exchange until a taxable event occurs.
Taxable Events:
• The exchanger converts the operating partnership units for REIT shares;
• The exchanger converts the operating partnership units for cash; or
• The subject property is sold by the operating partnership without acquiring a replacement property through a 1031 exchange.
Benefits:
• Real estate can be disposed of without incurring a taxable event.
• Investors can diversify their real estate investments in one transaction. By becoming an operating partnership unit holder, investors exchange interest in one property for interest in a larger and balanced portfolio of properties.
• Exchangers have the potential to gain greater liquidity. Units of an operating partnership can be converted into securities units, which can typically convert to cash more easily than a piece of real estate.
• The exchanger gains all benefits associated with institutional investing, including: passive ownership, quarterly distributions, management expertise, and more.
• If the units of interest are still owned at the time the exchanger passes away, the heirs would receive a step-up in cost basis, eliminating all previously deferred capital gains.
• The exchanger can lessen the tax impact by converting the operating partnership units over time, little by little paying the deferred taxes.
UPREITs:
Pure 721 exchanges are rare because most individual investors do not have property that large partnerships are interested in including in their portfolios. Practically, 721 exchanges happen in a 2-step process:
1. The investor sells the relinquished property and completes a 1031 exchange by acquiring an interest in a property designated by the partnership as the replacement property.
2. After a designated holding period, the investor contributes their portion of the property to the partnership through a 721 exchange for units in the operating partnership, usually known as an upREIT, Umbrella Partnership Real Estate Investment Trust.
Drawbacks:
• A 721 exchange will discontinue your 1031 exchange cycle. The exchanger no longer owns property that will qualify for a deferred tax under a1031 exchange.
• The partnership maintains authority to determine when to dispose of the contributed property; thereby having control over when the exchanger may experience a taxable event.
