At 1031 Exchange Place, we understand that having a tax-smart exit strategy for your real estate investments is critical. If you’re considering a 721 exchange as part of your plan, it’s essential to adopt a “buyer beware” approach. Here’s what you need to know before moving forward.
What is a 721 Exchange?
A 721 exchange, often referred to as an Umbrella Partnership Real Estate Investment Trust (UPREIT), is a strategy that allows real estate investors to defer capital gains taxes by converting their ownership in physical properties into operating partnership units (OP units) within a Real Estate Investment Trust (REIT).
This unique form of exchange is popular among investors who are looking for a way to diversify their portfolios, improve liquidity, and still benefit from the appreciation and income potential of real estate assets without the burden of direct property management.
The 721 exchange provides investors an opportunity to contribute property to a REIT’s operating partnership in exchange for OP units without triggering immediate tax liabilities. This is especially attractive for those who already own interests in a Delaware Statutory Trust (DST) through a 1031 exchange. As the real estate market evolves, more investors are seeking innovative ways to manage their portfolios, and the 721 exchange provides an effective exit strategy from a DST while maintaining many tax advantages.
However, this strategy is not without its risks and complexities. It’s essential to thoroughly understand the mechanics of the 721 exchange and evaluate both the DST and the REIT you’ll be transitioning into. While the tax advantages and diversification benefits are clear, the lack of control over the underlying assets and decisions made by the REIT managers should be carefully considered.
Section 721 Overview
Section 721 of the Internal Revenue Code is the legal framework that allows for a tax-deferred exchange of real estate assets into a REIT through the acquisition of OP units. In essence, this section enables property owners to defer capital gains taxes by contributing their real estate to a REIT’s operating partnership in exchange for equity (OP units) in the partnership, rather than cash or other forms of consideration.
Here’s a more detailed breakdown of how it works:
- No Immediate Tax Recognition:
According to Section 721, the contribution of property to a partnership (in this case, the operating partnership of a REIT) does not result in the recognition of gain or loss for tax purposes. This allows investors to avoid triggering capital gains taxes that would otherwise be due if the property were sold outright. - Conversion to Operating Partnership Units (OP Units):
When an investor contributes their property to the REIT’s operating partnership, they receive OP units in exchange. These units are similar to shares in the REIT but offer a unique tax advantage—investors maintain a tax-deferred status until they eventually sell or liquidate their OP units. - Long-Term Hold Strategy:
A key aspect of the 721 exchange is that it allows investors to hold their OP units indefinitely, deferring capital gains taxes for as long as they hold the units. This feature is particularly attractive to long-term investors seeking to maximize their tax advantages.
This provision allows for a more strategic exit from real estate ownership, especially for investors who may be at the end of their real estate investment lifecycle or those looking to step away from the hands-on management of physical properties. The 721 exchange is often seen as the final step in a broader tax-deferral strategy, such as moving from a 1031 exchange into a DST, then into a REIT through the 721 exchange. It allows investors to maintain exposure to real estate’s income and appreciation potential without the day-to-day management responsibilities.
Why Consider a 1031 Exchange DST with a 721 Exit Option?
While the 721 exchange offers numerous benefits, such as tax deferral, portfolio diversification, and liquidity, it’s important for investors to carefully evaluate various aspects before proceeding. These considerations can significantly impact the success of the investment and ensure that the investor’s long-term goals are aligned with the opportunities presented by the 721 exchange.
1. Understanding the Delaware Statutory Trust (DST)
Before participating in a 721 exchange, investors typically invest in a DST through a 1031 exchange. This intermediate step allows investors to own fractional interests in a property or portfolio of properties. However, it’s crucial to fully understand the DST structure, including:
- Asset Quality:
Examine the underlying properties in the DST portfolio. What is the condition of the properties? Are they in growth markets? Are they well-maintained and managed? Quality of the assets will directly affect both income potential and appreciation. - Management Team:
The experience and track record of the DST’s management team are vital to the success of the investment. How experienced is the team? How have they managed similar investments in the past? Investors need to trust that the managers are capable of optimizing asset performance and navigating market conditions. - Tenant and Lease Strength:
Who are the tenants occupying the properties? Are they long-term leases with stable, creditworthy tenants? The stability of rental income is essential for ensuring the distributions to DST investors and, eventually, to OP unit holders after the 721 exchange.
2. Evaluating the REIT in the 721 Exchange
Once you transition from the DST to a REIT via a 721 exchange, you will no longer hold direct ownership in individual real estate properties but instead will own operating partnership (OP) units within the REIT’s broader portfolio. Key factors to evaluate include:
- REIT’s Portfolio and Strategy:
Does the REIT invest in properties or asset classes you’re comfortable with? Is its investment strategy aligned with your risk tolerance and financial goals? The REIT’s ability to acquire, manage, and dispose of properties will directly affect your returns. - Asset Management and Performance History:
Take a deep look at the REIT’s past performance and management track record. How have they performed over various market cycles? What is their long-term growth strategy, and how do they manage risk in their portfolio? - Transparency and Reporting:
How transparent is the REIT in its operations? Regular and detailed reporting on financial performance, acquisitions, dispositions, and market conditions is critical for investors to make informed decisions about their OP units.
3. Liquidity Options
While 721 exchanges offer the possibility of increased liquidity compared to direct real estate ownership, it’s important to note that liquidity is not guaranteed. The REIT may offer redemption programs or allow investors to sell OP units, but these options are subject to certain conditions, including:
- Lock-Up Periods:
Some REITs have lock-up periods during which investors cannot liquidate their OP units. Understand how long you’ll be required to hold the units before you can access liquidity. - Limited Redemption Windows:
Even after the lock-up period, REITs may only allow investors to redeem OP units during specific windows, and the redemption amount may be discounted depending on the timing and market conditions. - Market Volatility:
Keep in mind that in times of market instability or economic downturns, REITs may suspend their liquidity programs to preserve cash flow. Investors should thoroughly review the offering materials to understand how liquidity is structured and what limitations may apply.
4. Optionality and Flexibility
Not all 721 exchanges offer the same level of flexibility. Some DSTs with a 721 exit option allow investors the choice to either participate in the 721 exchange or complete a new 1031 exchange upon exit, while others do not offer this flexibility. Investors should carefully consider whether they want to be locked into a 721 exchange or if they prefer the ability to execute another 1031 exchange in the future.
Changes in personal or financial circumstances can arise, making flexibility an important consideration. Investors should weigh their current and future needs when determining whether a 721 exchange fits into their broader real estate strategy.
Important Considerations for 721 Exchange Investors
While a 721 exchange offers many advantages, it is crucial to thoroughly evaluate both the DST and the REIT you are transitioning into. Consider the following:
- DST Structure:
Ensure you fully understand the DST’s investment strategy and how it aligns with your goals. - REIT Evaluation:
Investigate the REIT’s performance, asset management, and long-term strategy. Remember, you’re exchanging into an entity where you’ll have limited control over decisions. - Optionality:
Some 721 exchange UPREIT DSTs provide the option to participate in a future 1031 exchange or remain in the 721 structure, while others do not. Having flexibility can be crucial as your circumstances change.
Estate Planning and the 721 Exchange
One of the most compelling reasons to consider a 721 exchange is the role it can play in estate planning. Real estate investors often look for strategies that not only maximize their wealth during their lifetime but also allow for efficient wealth transfer to their heirs. A 721 exchange offers several important benefits in this regard.
1. Step-Up in Basis for Beneficiaries
Upon the death of an investor holding OP units from a 721 exchange, their heirs typically receive a step-up in basis. This means that the heirs can inherit the OP units at their current market value, rather than the original purchase price, potentially eliminating the capital gains tax liability on the appreciation of the property during the investor’s lifetime.
For example, if an investor’s original property appreciated significantly in value before it was contributed to the REIT, the heirs could avoid paying capital gains taxes on that appreciation when inheriting the OP units. This can result in substantial tax savings for the beneficiaries.
2. Flexibility for Heirs
The flexibility that OP units offer can be especially valuable for estate planning. Upon inheriting OP units, beneficiaries typically have the option to either:
- Hold the Units:
Beneficiaries can continue to hold the OP units and receive income distributions, allowing them to benefit from the ongoing performance of the REIT. - Liquidate the Units:
Alternatively, they can sell or redeem the OP units, converting them into cash. This provides liquidity and flexibility in how the estate is handled. However, it’s essential to remember that liquidity is not always immediate or guaranteed, and the timing of liquidation may be affected by market conditions or REIT-specific policies.
3. Avoiding Depreciation Recapture
In addition to capital gains taxes, depreciation recapture taxes can significantly reduce an investor’s wealth when selling real estate. However, the step-up in basis granted to heirs upon the investor’s death generally eliminates the need to pay depreciation recapture taxes, providing another layer of tax protection and ensuring that more of the estate’s value is preserved.
4. Simplifying the Estate
Many real estate investors own multiple properties, each requiring its own management, upkeep, and decision-making. This can become burdensome for heirs who may not be experienced in real estate management. By transitioning real estate holdings into OP units through a 721 exchange, investors can simplify their estate, reducing the need for active property management while still preserving the financial benefits of real estate ownership.
This simplification allows heirs to focus on managing their inherited assets without having to deal with the complexities of direct property ownership, such as leasing, maintenance, or tenant relations.
Is a 721 Exchange Right for Your Investment Future?
A 721 exchange offers real estate investors a unique opportunity to defer capital gains taxes, diversify their portfolio, and benefit from increased liquidity, all while transitioning out of active property management. For many, it represents the final step in a broader real estate investment strategy, providing a long-term solution that continues to offer income and appreciation potential.
However, the decision to participate in a 721 exchange requires careful consideration. Investors must thoroughly evaluate both the DST and the REIT involved, understand the liquidity options, and weigh the benefits and risks in light of their financial goals.
Moreover, the 721 exchange can play a significant role in estate planning, helping investors transfer wealth efficiently to their heirs through a step-up in basis and avoidance of depreciation recapture taxes. This strategy simplifies estate management while preserving the value of the estate for the next generation.
At 1031 Exchange Place, we are committed to helping our clients make informed decisions about their real estate investments. If you are considering a 721 exchange, our team of experts is here to guide you through the complexities and ensure that your strategy aligns with your long-term financial goals.
