Unlocking the Potential of the 721 Exchange
Investment property owners are continually seeking tax-efficient strategies that preserve long-term wealth while also offering potentially attractive returns. One strategy that has been gaining popularity among private real estate investors is the 721 exchange.
A Tax-Efficient Exit Strategy for Real Estate Investment Property Owners
Internal Revenue Code 721 enables property owners to contribute real property in exchange for interests in an operating partnership of a real estate investment trust (REIT) that is structured as an umbrella partnership real estate investment trust, or UPREIT. The benefits of exchanging properties into an UPREIT range from tax deferral of capital gains to converting to passive income streams. In this blog, we explore the 721 exchange/UPREIT transaction, its appeal, the intricacies of the exchange process, and its potential benefits and limitations.
The Appeal of the 721 Exchange
A few key factors making the 721 exchange/UPREIT strategy appealing include:
Tax-Deferral Structure: One of the primary draws of the 721 exchange is the ability to defer capital gains tax. By participating in a 721 exchange, a taxpayer can postpone the tax liability that would typically arise from selling the property outright. By maintaining the sale proceeds that would otherwise be paid out in taxes, more funds are available for reinvestment.
Passive Income: Owning real estate often comes with the responsibilities of property management, which can be both time-consuming and challenging. The 721 exchange allows a property owner to enjoy the benefits of real estate ownership without the hassles of day-to-day management. They become a passive investor in the portfolio.
Portfolio Diversification: Spreading risk across multiple institutional-quality properties is a cornerstone of a sound investment strategy. Through the 721 exchange, property owners may gain exposure to a diversified range of properties managed by experienced professionals, reducing the risk associated with individual property ownership.
Professionally Managed Assets: The expertise of institutional real estate managers can make a significant difference in the performance of your clients’ investments. Through a 721 exchange, they can potentially tap into the skills and knowledge of seasoned real estate professionals who handle property selection, management, and optimization.
Liquidity: Liquidity is a crucial factor in any investment strategy. UPREIT structures may provide investors with a redemption option, providing them access to liquidity.
Understanding the 721 Exchange Process: A Case Study
Let's walk through the step-by-step process of a 721 exchange. Suppose an investment property owner (Steve) is looking to sell his investment properties. He has several motivations and goals driving this decision.
Steve has owned his rental properties for years, and he is tired of the hands-on management and upkeep they require.
He wants to continue to own real estate but is looking for a passive ownership opportunity.
Steve’s properties have appreciated in value significantly, and he wants to avoid paying capital gains tax.
He would like to own a broad portfolio of high-quality commercial real estate diversified by property type and geography.
Finally, he would like to increase his liquidity options while also maintaining his step-up basis for estate-planning purposes.
Steve is looking for a tax-efficient investment strategy that preserves wealth while offering strong returns. He sees investing in an UPREIT through a tax-deferred 721 exchange as a potential solution. However, a key challenge he faces is that, likely, most, if not all, large institutional REITs will not acquire individual properties or small portfolios, leaving Steve to wonder how he can align his investment goals with the strategic investment thesis of the UPREIT.
The 721 Exchange via Delaware Statutory Trust (DST)
Steve’s in luck! He may still achieve his goal of transforming his investment property into ownership in an UPREIT on a tax-deferred basis through a combination 1031/721 exchange using a DST as a conduit. Combining a 1031 exchange with 721 is an elegant solution allowing investors to transform investment property into operating partnership units.
To complete this type of exchange, Steve first sells his investment properties and invest his proceeds into a DST that is designated for a 1031/721 program.
In the case of 721 DSTs there is typically a shorter hold period than traditional DSTs and average at least two years.
At the end of the hold period, and assuming the REIT exercises its option to acquire the assets of the DST, Steve’s interests in the DST will be exchanged for OP Units of the REIT - completing the 721 portion of the exchange.
After holding OP Units for one year, Steve has the option to access liquidity through the UPREIT’s redemption program. However, capital gains tax may be due when his OP units are redeemed for cash or converted to REIT shares.
Ultimately, Steve decides (for estate-planning purposes) to bequest equal amounts of this OP Units to his son and daughter. This allows them to receive the step-up basis and enabling them to make their own decision of whether they want to remain invested while still deferring the original capital gains tax or redeem their OP Units, which again is a taxable event.
The hypothetical described above is only one example of the potential benefits a 721 exchange transaction can offer real estate investment property owners. As the trend toward this strategy continues gaining momentum, it's important for investors to be aware of all regulations and potential limitations associated with this sophisticated investment strategy. Consult a knowledgeable financial professional regarding how a combination 1031/721 via DST transaction may impact investment goals.
