My phone rang – it was Lisa, calling me to ask what their apartment building was worth. “My husband, Tim, recently fell off of a ladder when he was trying to paint some trim at one of our apartment buildings,” said Lisa. “Thankfully he’s not injured. But, at that moment, I knew the time had come for us to retire from being landlords.”
Time and Lisa represent so many hard-working American landlords who started with nothing and built a substantial portfolio over many years. They built their own management team to lease and manage their portfolio, and now they can rest easy knowing their future years will be free from financial worries.
For many landlords, when it comes time to sell, the tax bill they will incur with a sale can leave them dead in the water. To work diligently for so many years, and then see the IRS take 15-20% of your earnings with one scoop of their net at sale time, is disheartening.
On the flip side, Lisa and Tim field calls almost every day from young investors hustling to get their feet wet in the real estate game, seeking to purchase their properties. They’re ready to sell, and know there will be buyers, but where should they put the money when they sell? And how can they avoid the taxes?
Aside from the classic 1031 Exchange – which has its downsides and limits – what other options are there to help experienced investors reduce their work, without a portion of the sale profits being skimmed off?
Consider a 721 Exchange
The 721 Exchange, often referred to as a Section 721 Exchange or a 721 UPREIT (Umbrella Partnership Real Estate Investment Trust) Exchange, is a potentially advantageous tax deferral strategy for real estate investors. While it may not be as commonly discussed as the 1031 Exchange, it offers unique benefits – especially for those looking to diversify their real estate holdings and reduce their workload without triggering immediate tax liabilities.
What is a 721 Exchange?
The 721 Exchange is a provision under Section 721 of the Internal Revenue Code (IRC) that allows real estate investors to defer capital gains taxes by contributing their property to an UPREIT in exchange for Operating Partnership Units (OP Units) – unlike a 1031 Exchange, where one property is swapped for another.
In essence, the investor trades direct ownership of the real estate for an ownership interest in a portfolio properties managed by the UPREIT. The OP Units received can later be converted into shared of the REIT or cash out, though cashing out may trigger capital gains.
How does a 721 Exchange work?
- Identify a suitable UPREIT: The first step in a 721 Exchange is to identify an UPREIT that is interested in acquiring your property. UPREITs typically target large, income-generating properties such as commercial real estate, apartment complexes, or large office buildings.
- The Two-Step: More often than not, an investor may own a property that an UPREIT is not interested in acquiring. This can be solved by a two step process:
- Step 1: First, the investor conducts a 1031 Exchange where they sell the property and exchange into a Delaware Statutory Trust (DST), which is suitable for a 1031 Exchange. DSTs are usually fractional ownership in one or several very large properties, which provides diversification and passive investment. However, they are rather illiquid, which can limit the ability to dispose of the investment in future years, should the money be needed by the investor (like Tim and Lisa, who are planning to retire!)
- Step 2: The resolution is then conducting a 721 Exchange from the DST into the operating partnership of the UPREIT, which can then be converted into shares and more easily sold.
- Conversion to UPREIT Shares: At a future date, the investor can choose to convert the OP units into UPREIT shares. This conversion process may trigger capital gains taxes, but it also offers the benefit of increased liquidity, as REIT shares can be sold on the stock market. They can also be sold in factions, rather than all at once, which limits how much tax is triggered at one time on the investment – and provides more return of investment as it is needed. The investor receives the same passive income and diversification, with more liquidity for redemption.
Benefits
- Deferred Taxes: The primary benefit is the deferral of capital gains taxes. The investor’s tax basis in the property carries over to the OP units received, effectively deferring the tax liability until the OP units are converted into REIT shares or sold for cash.
- Diversification: One significant advantage is the diversification it offers. Instead of owning a single property, the investor now holds an interest in a diversified portfolio managed by the UPREIT. This diversification reduces the risk associated with owning a single asset and provides the investor with more flexibility.
- Professional Management: The UPREIT structure involves professional management of the real estate portfolio, relieving investors of the day-to-day responsibilities of property management.
Possible Risks
While the 721 Exchange offers numerous advantages, it is not without risks to consider.
- Tax Implications: While the initial exchange is tax-deferred, eventual conversion to REIT shares or sale of the OP Units may trigger capital gains tax. Investor must carefully plan their exit strategy to manage these liabilities.
- Limit of Exit Options: Once the real estate (either DST or direct real estate) is exchanged into an UPREIT, there is no going back or further exchange. The only exit option is to sell the UPREIT shares and pay the tax. If the property will be left to heirs with a step up in basis, this can be an easier exit for them than selling individual real estate.
- Lack of Control: Investors in a 721 Exchange relinquish direct control of their property. While this can be beneficial in terms of reducing management responsibilities, it also means they have less say in the operation and management of the underlying assets.
Conclusion
The 721 Exchange represents a compelling option for real estate investors seeking to diversify their holdings, defer taxes, and gain liquidity. By contributing a property to an UPREIT in exchange for OP Units, investors can transition from direct property ownership to a more diversified and professionally managed portfolio. However, as with any investment strategy, the 721 Exchange requires careful consideration of the potential risks and benefits. Investors should consult with tax professionals and financial advisors to determine whether this strategy aligns with their long-term financial goals.
Looking to invest in more passive real estate options? Many of our clients have benefitted from our recommendations to diversify and reduce their active management work. Contact us for connections into this passive real estate market.