721 Exchange | UPREIT Explained
Investing in real estate is exciting; that is, until you sell one of your properties. When you sell your first property, you’ll quickly learn that capital gains taxes are a significant burden that could end up costing you anywhere between 20% and 40% of your profits.
Some investors use 1031 exchanges as an effort to defer these taxes. The exchanges give the investor the opportunity to defer taxes by investing in like-kind property. However, 1031 exchanges don’t meet the needs of all investors.
For some investors, a 721 exchange or a mix between 721 and 1031 exchanges is the better option.
What Is a 721 Exchange?
A 721 exchange, also known as the UPREIT, gives you the ability to get rid of a property while deferring capital gains taxes associated with the sale. However, unlike 1031 exchanges, 721 exchanges don’t require you to invest your proceeds from the sale into a like-kind property.
Instead, with a 721 exchange, you don’t sell your property; you trade it to a real estate investment trust (REIT) in exchange for shares in the trust. This specific exchange gives you the same tax deferral you’d enjoy with a 1031 exchange while allowing you to take a hands-off approach to real estate investing.
How Does a 721 Exchange Work?
A 721 exchange follows the steps below:
- You want to relinquish control of the real estate.
- You sign the real estate over to a REIT.
- You enjoy tax-deferred status on your capital gains obligations from the sale of your real estate.
The most important part of this is exchanging shares in a REIT as part of a trade for your real estate. A REIT operates like a mutual fund except instead of own a portfolio of stock, it own a portfolio or real estate. REIT managers pool investment dollars from a wide group of investors. The REIT uses those investment dollars to purchase, maintain, and manage real estate investments, typically in an attempt to generate rental income.
In exchange for your property, you receive shares equal to the value of your property in the REIT,, including all properties and the income they generate. REITs are required by law to pay out at least 90% of their profits to investors annually, but some will follow other dividend payment schedules.
What Are the Advantages of a 721 Exchange?
There are several advantages to using the 721 exchange when you sell a real estate investment. Some of the largest advantages are centered around taxes, diversification, passive income, and estate planning benefits. Read on below to learn the details of each.
The sale of a real estate investment can leave you with a significant tax burden. In a typical real estate sale, the capital gains portion of the transaction is taxed. This is the difference between the amount of money you purchase the property for and the amount of money you sell it for, or your profits. On top of the capital gains tax, you’ll also pay tax on the depreciation that was used to offset property taxes. Between the two, you could pay more than a quarter of your gains in taxes.
This means you have substantially less money to reinvest.
In a 721 exchange, the taxes associated with the trade of real estate are deferred by using it as an investment in a REIT. This means you’ll be able to reinvest 100% of your property’s value.
Diversification is an important part of any investment portfolio. It’s the practice of spreading your investment dollars across a wide range of assets and asset classes. This helps because if a single asset or small group of assets in your portfolio takes a hit, gains from other assets in your portfolio help to soften the blow. Many larger REITs may have hundreds or even thousands of properties.
If you don’t already have REITs in your portfolio, this could be the perfect opportunity to add them.
There’s nothing like cashing a check every month, quarter, or year that you didn’t have to go to work for. REIT investments are passive income investments that provide regular income.
As mentioned above, REITs are legally required to pay 90% of their profits as dividends to investors on at least an annual basis. Some funds may make these payments more frequently, with monthly and quarterly dividend schedules being commonplace in the industry.
Nonetheless, when you invest in a quality REIT, you can typically count on regular passive income as a result of your investment.
The 721 exchange process also adds a level of simplicity to estate planning. That’s because including real property in an estate plan can create family feuds. After all, some members of the family may want to sell properties while others might want to hang onto them. Moreover, it may be difficult for family members to divide proceeds evenly and fairly after a sale.
REIT shares alleviate that headache.
That’s because REIT shares each represent fractional ownership of the real estate investment trust. Since each share has a relatively small value, it’s easier to split them up in your will to ensure the legacy you leave behind is the one you planned on.
Combining 1031 and 721 Exchanges
In some cases, a 1031 exchange and a 721 exchange miss the mark when it comes to providing the type of protection you’re looking for.
You may decide that you want to sell your real estate to a REIT in exchange for shares of the REIT, but chances are your real estate doesn’t meet the acquisition criteria set by the REIT. In this case, you can use a 1031 exchange to purchase fractional shares in real estate the REIT is interested in acquiring. After 24 months of ownership, you can do a 721 exchange with the REIT, using your real estate to purchase shares of the trust.
Can You Do a 1031 Exchange After a 721 Exchange?
Seeing that you can do a 721 exchange following a 1031 exchange is exciting, but can you do that in reverse? No. A 1031 exchange requires a like-kind investment from the proceeds of the sale of real estate. Although REITs do fall in the real estate category, they’re not like-kind in terms of traditional real estate. Therefore, you can’t do a 1031 exchange once you’ve converted your real estate into shares of a REIT through a 721 exchange.