Many investors are familiar with the 1031 Exchange as a tool for deferring taxes on property sales. However, the 721 Exchange, while lesser known, offers investors a compelling alternative to tax-deferred real estate investing.
While the 721 Exchange and 1031 Exchange strategies differ in many respects, they share one common goal: a tax-deferred real estate investing strategy. The 721 Exchange enables a smooth entry into the REIT space without incurring immediate tax liabilities. Understanding this alternative may offer real estate investors fresh options as they consider their real estate exit strategies.
Understanding the Basics of 1031 Exchanges
1031 Exchanges offer real estate investors a powerful tool for tax deferral. The basic steps to a successful 1031 exchange include the following steps:
Step One:
The exchanger closes escrow on down-leg property, and funds are transferred to a Qualified Intermediary.
Step Two:
The exchanger has 45 days to identify the chosen replacement properties with his/her Qualified Intermediary.
Step Three:
The investor must close on a “like-kind” replacement property earlier than 180 days after closing on the sale of the relinquished property or the due date for filing the tax return for the year the relinquished property was sold unless an automatic filing extension has been obtained.
Many investors confuse “like-kind” to mean the type of property that must be exchanged for the same type of property. For example, an apartment building for another apartment building, etc. However, for the 1031 exchange, like-kind refers to the nature of character of a property and that it must be held for productive use in a trade, business, or investment.
Some benefits investors enjoy with a 1031 Exchange include tax deferral, potential escalating portfolio growth, and even long-term legacy and estate planning. By reinvesting in additional investment real estate via the 1031 exchange, investors can keep more capital working for them and potentially build a larger portfolio over time.
The 1031 exchange is perhaps one powerful real estate investment tool. However, it does come with some challenges. For example, finding suitable like-kind properties within a tight timeline can be challenging, and being aware of the specific rules associated with the 1031 exchange is critical to follow closely. As always, it is important to consult your CPA or tax attorney before pursuing a 1031 exchange.
What is the 721 Exchange?
A 721 exchange is governed by Section 721 of the Internal Revenue Code. It gives real estate investors a unique opportunity to transition property ownership via a 1031 exchange into an umbrella partnership real estate investment trust (UPREIT). This strategy offers similar tax-deferral advantages to the 1031 Exchange and can work as a potential exit strategy for Delaware Statutory Trust investors.
“The process of a 721 Exchange involves transferring real estate into a REIT, in exchange for operating partnership units rather than cash, thus avoiding immediate capital gains taxes,” says Dwight Kay. “These units typically offer a stake in a larger, diversified portfolio, with the potential for appreciation. Diversification does not guarantee profits or protection against losses; however, it is something investors are advised to consider.”
Over time, they can be converted into REIT shares, typically after a lock-up period. The exchange provides the same tax deferral benefits as the 1031 Exchange but also provides investors additional benefits such as the potential for greater diversification, potential for income and appreciation, and greater liquidity.
Hypothetical Case Study on How Investors Can Combine the 1031 Exchange and the 721 Exchange
Investor Profile
Imagine an investor who owns a $150,000 interest in a debt-free Delaware Statutory Trust (DST) that holds a single-tenant net lease industrial distribution facility. When the DST runs full-cycle, the investor must decide their next steps. This investor wants to optimize their portfolio, maximize diversification, and potentially achieve long-term financial goals while maintaining tax advantages. This investor may unlock significant opportunities by utilizing 1031 and 721 exchanges.
The Transition
Through the 1031 exchange, the investor originally deferred capital gains taxes on selling a previous property by reinvesting into the DST. By completing a 721 exchange, the investor contributes their DST interest into an operating partnership (OP) structure. This strategic move provides access to the broader benefits of the 721 vehicle.
Key Benefits of the 721 Exchange
- Full Tax Deferral
The investor continues to defer taxes through the 721 exchanges, preserving capital for reinvestment and growth. - Diversification
Instead of owning a single industrial distribution facility DST, the investor is interested in a vast portfolio comprising over a million square feet of properties.
* Diversification does not guarantee profits or protection against losses.
- Tenant Exposure Across Multiple States
The investor’s reliance on a single tenant is replaced by a diverse pool of tenants operating in multiple industries and geographic locations, reducing risk. - Upside Potential
By participating in the entire portfolio, the investor gains exposure to its appreciation potential and enterprise value, which extends beyond the original DST investment. - Enhanced Income Stream Potential
The investor benefits from multiple potential income streams from diverse tenants, asset classes, and locations. - Increased Return Potential
The 721 vehicle is designed to optimize income through accretive acquisitions, strategic dispositions, and portfolio enhancements, potentially increasing returns over time. - Tax Advantages
Income distribution potential is often tax-advantaged through depreciation and other write-offs, reducing the investor’s taxable income while enhancing cash flow. - Liquidity Potential
The investor can potentially liquidate shares partially or entirely, subject to the liquidity provisions outlined in the Private Placement Memorandum (PPM). This flexibility is invaluable for managing financial needs. - Estate Planning Benefits
Upon the investor’s death, OP units can be evenly divided among beneficiaries, who can either retain or liquidate them. Beneficiaries also receive a step-up in basis, eliminating capital gains and depreciation recapture taxes.*
Conclusion
By combining the 1031 and 721 exchanges, this investor effectively transitions from a concentrated, single-property Delaware Statutory Trust investment into a diversified portfolio with growth potential, tax advantages, and financial flexibility. These tools, working in tandem, empower investors with a strategy to potentially build wealth while seeking to safeguard their financial legacy.
The Future of 721 Exchanges
The future of the 721 UPREIT exchange is poised for significant growth as investors and real estate professionals become more familiar with its potential as a powerful tax-advantaged building block investment strategy. By contributing property to a REIT in exchange for operating partnership (OP) units, investors gain a pathway to defer capital gains taxes while diversifying their portfolios. As REITs expand and attract institutional investment, the 721 exchange is expected to become a more prominent tool for those seeking liquidity, estate planning flexibility, and access to professional property management. Increased knowledge of and adoption of the 721 exchange strategy will likely enhance its appeal, making it a cornerstone of tax-efficient investing in the years ahead.
About Kay Properties and www.kpi1031.com:
Kay Properties helps investors choose 1031 exchange investments that help them focus on what they truly love in life, whether their children, grandkids, travel, hobbies, or other endeavors (NO MORE 3 T’s – Tenants, Toilets, and Trash!). We have helped 1031 exchange investors for nearly two decades exchange into over 9,100 – 1031 exchange investments. Please visit www.kpi1031.com to access our team’s experience, educational library, and full 1031 exchange investment menu.
This material is not tax or legal advice. Please consult your CPA/attorney for guidance. Past performance does not guarantee or indicate the likelihood of future results. Diversification does not guarantee returns and does not protect against loss. Potential cash flow, potential returns, and potential appreciation are not guaranteed. There is a risk of loss of the entire investment principal. Before investing, please read the Private Placement Memorandum (PPM) for the offering’s business plan and risk factors. Securities offered through FNEX Capital LLC member FINRA, SIPC.
Disclaimer: This content is for informational purposes only and is not intended as financial advice, nor does it replace professional financial advice, investment advice, or any other type of advice. You should seek the advice of a qualified financial advisor or other professional before making any financial decisions.
Published by Elle G.
