By Eric Rosenberg, WCI ContributorInvesting in real estate opens up opportunities to strategically sell your property and acquire another, all while sidestepping the capital gains taxes typically required from a real estate sale. A popular method to achieve this is a 1031 exchange, though other paths are available. Here’s a look at how to use a 721 exchange to defer and potentially bypass capital gains taxes and a comparison of 1031 vs. 721 exchanges to help you understand which could make the most sense for your financial goals.
What Is a 721 Exchange?
A 721 exchange, sometimes called an UPREIT (Umbrella Partnership Real Estate Investment Trust), is a real estate transaction in which an investor can sell a property and use the proceeds to buy a new property without paying capital gains taxes right away. If you’re holding commercial or rental real estate with a significant gain, a 721 exchange can save you a bundle in taxes when upgrading to a new investment property.
When you sell the first property, you don’t get to take the cash as with a regular, taxable sale. Instead, a designated third party, typically a title company, holds the funds until you’re ready to buy the second property. In a 1031 exchange, you work more or less independently when buying a new investment property. But with a 721 exchange, you work with a Real Estate Investment Trust (REIT) to buy the new property and become an owner of the REIT over time.
More information here:
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721 Exchange Rules
When participating in a 721 exchange, the following rules apply. If you’re in doubt, contact a tax professional to get advice on your situation so you don’t make any expensive missteps.
Property Sale
The first step is to sell a property. Rather than take the proceeds, a third party holds the funds for your future real estate purchase. Investors have 45 days to identify their next investment property and 180 days to complete a purchase.
Property Contribution to UPREIT
Next, the investor contributes their property to an umbrella partnership or operating partnership (OP) within an UPREIT. When the property contribution occurs, the investor receives ownership units in the REIT. As a unitholder, the investor becomes a partner in the OP.
Income Distributions
The REIT technically owns the contributed properties and handles the management and operations. Instead of traditional owner distributions, the REIT investors get dividends proportional to their ownership. This arrangement offers investors a passive income stream without the hassle of managing the individual property.
Conversion to REIT Shares
Unitholders can exchange their OP units for shares in the REIT, potentially enhancing liquidity. can be sold similarly to stock, offering a clear path to cash out on their investment when desired. They can also sell a small portion of the investment rather than the entire investment at once.
721 Exchange Pros and Cons
721 exchange transactions are not perfect for everyone. While they offer a great alternative to a 1031 exchange, you should consider these pros and cons if you’re considering a 721 exchange.
Pros
- Keep more cash in hand with tax deferral: This strategy lets you put off capital gains taxes, so you don't have to hand over a chunk of your profits immediately.
- Broaden your portfolio with diversification: Swapping your property for OP units means you're no longer investing in one property. Now, you're part of a bigger pool of investment properties, adding potentially valuable diversification.
- Easy exit with liquidity: Once you've switched to REIT shares through a 721 exchange, you have more options when selling. These shares are sometimes on the public market, making them simpler to sell if you decide to cash out. In any case, you can sell a portion of your portfolio at a time rather than selling all at once.
- Simplify your estate planning: Compared to dealing with direct real estate, REIT shares are easier to manage when planning your estate. They're simple to split among heirs and liquidate, taking some of the headaches out of estate planning.
- Earn without the effort with passive income: One of the sweetest perks is getting those regular dividends without having to manage any property directly. It's a more hands-off approach to earning from real estate.
Cons
- Watch for market swings with potential for capital loss: Just like any investment, REIT shares can go up and down, which means there's a risk you might not get back what you put in.
- Unexpected tax events with unforeseen capital gains: Sometimes, decisions made by the REIT can lead to taxable events for you. It's a somewhat unpredictable element that could impact your financial planning.
- Legacy assets: Pre-owned properties within the REIT's portfolio may not perform as expected, potentially pulling down your returns.
- Face a higher tax bill with increased tax liability: Dividends from REITs may come with a higher tax rate than other types of investment income, which could mean a larger total tax bill for you.
- Lock-in with loss of flexibility: Once you've made a 721 exchange, that's it. Your property is now in REIT shares, and you're limited from participating in other tax-deferred real estate moves.
More information here:
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Can an LLC Do a 721 Exchange?
According to IRS rules, an LLC can participate in a 721 exchange. If you own one or more properties through an LLC, the LLC can sell a property and contribute a new one to an UPREIT, and the LLC becomes the owner of the new REIT units and, eventually, REIT shares.
Depending on how your LLC is structured, this could offer additional tax benefits over conducting a 721 exchange as an individual. The LLC can be structured as a partnership, where you share the risks and rewards with other LLC members. In some circumstances, you can also opt for S Corp taxation, helping you save on self-employment taxes from your LLC.
Again, if you’re in doubt, discussing the pros and cons of a 721 exchange for your LLC with a trusted tax professional is a good idea.
1031 Exchange vs. 721 Exchange
When comparing a 1031 exchange vs. a 721 exchange, you have two distinct strategies for deferring capital gains taxes in real estate, each suited to different investment and tax goals.
The 1031 exchange lets investors defer taxes by reinvesting proceeds from a sold property into another “like-kind” property. This is ideal for those aiming to continuously reinvest in real estate while avoiding immediate taxes.
Conversely, the 721 exchange enables investors to convert real estate into REIT shares or units, deferring taxes and shifting from active to passive investment roles. While a 1031 exchange focuses on reinvestment continuity, a 721 allows for diversification and liquidity, offering access to various real estate sectors without direct management burdens.
More information here:
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Bottom Line on 731 Exchange Transactions
If you’re a doctor investing in real estate, you’re far from alone. And wanting to take advantage of tax benefits when selling is a savvy financial decision. If you want to switch from managing your own portfolio of investment properties to teaming up with others in a REIT, a 721 exchange offers a route to do so while deferring and potentially saving on taxes.
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Thank you for the informative article. Question: once I complete the 721 exchange, do I continue to get depreciation as if I own real estate? and would this depreciation reduce my tax from my w2 job?
Generally not. Although a REIT can “kind of” pass through depreciation by labeling distributions as return of principal.
Would you please shed some light on my situation:
I own a single family house rental (via a single member LLC). It appreciated $600k in value. I want to sell it and defer capital gains and depreciation recapture. I’ll try to find an UpReit to do this where I’ll own “operation Units”.
Questions:
1: Do I have to hold onto these Operating units till I die, otherwise I’ll pay tax?
2: What if this UpREIT goes bankrupt or whatever else, what happens to my shares?
3: How much shall I expect in annual dividends (rough range)?
Thank you so much.
I’ll say the same thing I posted on the other thread you posted this question on:
1. Yes.
2. You lose all your money.
3. Depends on the REIT, but likely in the 3-10% range.