Both 721 exchanges, also known as UPREITs, and 1031 exchanges are powerful tools for deferring capital gains taxes. Depending on your personal and financial goals, one investment vehicle may be preferred.
This article will educate you on the differences, benefits, and considerations of 721 exchanges compared to 1031 exchanges to help make the most informed investment decisions.
What is a 1031 Exchange?
A 1031 exchange, named after Section 1031 of the Internal Revenue Code, permits real estate investors to defer capital gains taxes when selling one investment property and reinvesting the proceeds into another of like-kind. The strategy is widely used to preserve equity, build wealth, and expand or reposition real estate portfolios.
Key Requirements
To complete a successful 1031 exchange, investors must meet several core conditions:
- Like-Kind Property: The replacement property must be “like-kind,” meaning it must be real estate held for investment or business purposes, exchanged for another property of the same nature or character.
- Identification Period: Within 45 days of selling the relinquished property, investors must identify potential replacement properties in writing to their Qualified Intermediary (QI). They must follow one of three IRS identification rules—the Three-Property Rule, the 200% Rule, or the 95% Rule—and ultimately acquire one or more of the properties they identified.
- Exchange Period: The new property must be acquired within 180 days of the sale.
- Qualified Intermediary (QI): A QI must facilitate the exchange by holding the proceeds from the sale. This prevents the investor from taking constructive receipt of the funds, preserving the tax deferral benefits.
Benefits
- Tax Deferral: Investors can use full sale proceeds to buy larger properties and maximize purchasing power on a tax-deferred basis.
- Cash Flow: 1031 exchanges allow investors to swap low-earning assets for income-generating properties, potentially increasing long-term returns.
- Estate Planning: Deferred taxes are eliminated at death, letting heirs inherit properties tax-free with a stepped-up cost basis.
Risks
- Strict Timelines: 1031 exchange timing is precise, and failing to meet any rules or timelines can result in a failed exchange.
- Illiquidity: Investors typically hold them for at least two years to meet IRS requirements and avoid disqualification.
DSTs for 1031 Investors
Delaware Statutory Trusts, or DSTs, have emerged as an increasingly popular and powerful solution for investors executing a 1031 exchange. These legal entities hold title to real property, allowing multiple investors to own a fractional, beneficial interest in the underlying real estate. For tax purposes, this beneficial interest is considered direct ownership of real property, making DSTs a qualified replacement property under Section 1031.
DSTs are particularly well-suited for investors seeking passive income, tax deferral, and diversification within their 1031 exchange strategy, especially those looking to reduce management responsibilities or access larger, institutional properties. Understanding their specific benefits and how they compare to other investment vehicles is vital for making an informed decision.
What is a 721 Exchange?
To make informed financial decisions, real estate investors should understand both 1031 and 721 exchanges. A 721 exchange is a tax-advantaged investment strategy that allows investors to contribute real estate to a partnership in exchange for ownership interests—typically in the form of operating partnership (OP) units. This process is facilitated through an UPREIT (Umbrella Partnership Real Estate Investment Trust) structure.
The term “721 exchange” refers to Section 721 of the Internal Revenue Code, which permits tax-deferred contributions of property to a partnership. Instead of selling a property and triggering capital gains, investors contribute it to a Real Estate Investment Trust (REIT) and receive OP units within the REIT’s operating partnership.
In a typical UPREIT structure:
- The REIT owns 100% of the Operating Partnership (OP).
- The OP owns 100% of various Special Purpose Entities (SPEs), which each hold individual real estate assets.
OP units grant investors an interest in the partnership, rather than direct REIT shares or cash. Over time, these units may be converted into REIT shares—a taxable event that also provides liquidity. Until conversion, investors generally have limited liquidity and may face holding periods or restrictions.
Benefits
- Tax Deferral: Investors can defer capital gains taxes by contributing appreciated real estate to a REIT’s operating partnership instead of selling the property outright. This allows for a strategic transition into passive real estate ownership without an immediate tax burden.
- Passive Income: With a 721 tax-deferred exchange, investors exchange direct ownership for UPREIT units, relieving them of management duties. The UPREIT handles operations and distributes income.
- Liquidity*: Investors can increase the liquidity of their real estate investment by exchanging the property for OP units. Those units can then be converted into REIT shares and sold.
- Diversification: Contributing property to a REIT allows investors to diversify their exposure across multiple real estate assets, sectors, and geographic regions.
- Estate Planning: With a 721 exchange, heirs inherit OP units, which can be converted to REIT shares and sold or held for income. Upon the investor’s death, OP units can be converted and divided among heirs, who receive a step-up in basis and may either hold the shares for dividends or sell them for cash.
Risks
- Limited Control: 721 exchanges are passive investments, meaning OP unitholders are not directly involved in managing properties within the REIT’s portfolio.
- Unexpected Taxable Event: Investors have control over when they convert their OP units 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 an unexpected taxable event.
- No Longer 1031 Exchange Eligible: You cannot perform a 1031 exchange after engaging in an UPREIT transaction. When an investor exchanges the property for units of equity interest in an OP, 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.
721 Exchanges vs. 1031 Exchanges: Key Differences
Category | 1031 Exchange | 721 Exchange |
Property Type | Must be “like-kind” real estate used for investment or business purposes. | Contribution to a REIT must be accepted by the REIT sponsor, which limits flexibility and availability. |
Timeline | Strict deadlines: identify new property within 45 days; purchase within 180 days. | No specific IRS deadlines, offering more timing flexibility. |
Liquidity | Typically limited, as selling the property may trigger taxes unless another 1031 exchange is completed. Liquidity can vary depending on the structure or investment vehicle used. | Liquidity depends on the REIT’s share redemption plan and timeline. OP units may eventually convert to REIT shares, which can offer more liquidity than some structures—such as DSTs—but this varies by offering. |
Control | Investors’ control varies depending on the replacement property or vehicle chosen. There are both active and passive investment vehicles, such as a DSTs, that can satisfy a 1031 exchange. | Investors give up control; REIT manages assets and distributes passive income. |
Tax Implications | Capital gains taxes are deferred until the replacement property is sold for cash. | Capital gains taxes are deferred until OP units are converted into REIT shares and sold. |
Investment Goals | Suitable for investors seeking tax deferral, passive or active management, potential diversification, and estate planning advantages. | Suitable for investors seeking tax deferral, passive income, diversification, and estate planning advantages. |
Considerations and Due Diligence
Before pursuing a 1031 or 721 exchange—or exploring investment structures like REITs or DSTs—consult with qualified tax and legal professionals. These strategies offer significant tax benefits, but each comes with unique requirements and implications that require careful evaluation..
Ready to Exchange? Find Your Ideal Investment
Both the 721 and 1031 exchanges offer valuable tax deferral strategies, but serve different investment paths. No matter which strategy you choose, aligning your exchange with your personal investment goals is key. Think about your desired level of control, income needs, risk tolerance, and timeline for liquidity.
Explore the extensive tools and resources at 1031 Crowdfunding to better understand which investment vehicle or strategy fits your situation. Ready to talk to a professional? Register for an investor account with 1031 Crowdfunding today for personalized guidance and help identifying the right investment opportunities.
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, 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.
