Most real estate investors are familiar with the IRC Section 1031 exchange and have most likely been closely involved with a 1031 exchange in one form or another. The Section 1031 exchange has become a popular way for sellers to dispose of appreciated real estate and to defer capital gains taxes and depreciation recapture taxes.
Many of these same real estate investors that have utilized the Section 1031 Exchange time and time again have not heard of another powerful tax deferral tool allowed by the tax code, which is the IRC Section 721 exchange. The Section 721 exchange is typically used by Real Estate Investment Trusts (REITs) to acquire real estate from sellers that often don’t want to pay large capital gains taxes. (1)
Here’s how it works: instead of selling a property and doing a 1031 exchange to defer taxes, the seller contributes his property to a REIT’s Operating Partnership in exchange for Operating Partnership Units (the Operating Partnership is the entity through which all REITs typically acquire and own their properties). This is all done on a tax-deferred basis utilizing the IRC Section 721 exchange.
This transaction is referred to either as a 721 exchange or an UPREIT (Umbrella Partnership REIT). Now the seller in exchange for his property (which is considered by the IRS to be “like kind” property) has Operating Partnership Units, which are equivalent and can be converted to shares of the REIT, on a tax-deferred basis.
Along with tax deferral, other potential benefits include the ability to realize the economic benefits of the REIT’s entire property portfolio (including distributions of potential monthly operating income, potential capital appreciation and property diversification*), liquidity options by partial conversion of OP Units to REIT shares (he can “peel” off what he needs to and pay the taxes on just that amount), the ability to fully divide his OP Units for estate planning among his heirs and, lastly, the ability to provide his heirs with a step up in tax basis, just as he would have been able to with his individual property.
The main caveat to the Section 721 exchange is that once an investor proceeds with the exchange, he loses the ability to continue 1031 exchanging and deferring taxes. He now only has the option to convert his Operating Partnership Units to REIT shares and pay his capital gains tax. Therefore investors who are in the midst of estate planning and who know that, upon their passing, their heirs will receive a step up in tax basis, which will eliminate the capital gains tax, often will consider the Section 721 exchange.
Other potential risks can include, but are not limited to, the REIT’s management team making poor decisions (which could possibly cause properties to perform poorly and values to decline) and exposure to stock market volatility if the REIT they exchange into is publicly traded on a stock market.
Again, many investors have never heard of a Section 721 exchange because REITs typically will only acquire properties of institutional quality. This often leaves most investors out of reach of the 721 exchange and typically keeps it available to only institutional sellers.
However, I have seen the IRC Section 721 exchange made available to smaller investors through two distinct models. First is where a large REIT removes one of its institutional quality buildings from its portfolio and makes it available for individual investors to do a 1031 exchange into and hold title to it as a beneficial interest in a Delaware Statutory Trust (DST) or as a Tenant in Common (TIC) owner. The REIT, however, leaves a two- to eight-year call option on this building with the intent of “calling” it back into their Operating Partnership whereby the investors each contribute their DST interests in the building to the REIT’s Operating Partnership in exchange for Operating Partnership Units on a tax-deferred basis, utilizing the IRC Section 721 exchange. (2)
The second model is whereby an investor is able to present his property to the REIT for evaluation. The REIT will not automatically accept the owner’s property unless it has deemed the owner’s selling value is reasonable, after which the seller will contribute his property to the REIT’s Operating Partnership in exchange for Operating Partnership Units on a tax-deferred basis, utilizing the IRC Section 721 exchange.
Both of these models are used by REITs as a way to raise capital for their investment trusts. The resulting situation is potentially beneficial for both parties: the REIT has now raised a substantial amount of capital with one transaction, and the investor now has diversified his portfolio from one property to potentially hundreds (depending on the size of the REIT) on a tax-deferred basis.
The Section 721 exchange has been titled by Real Estate Weekly as “one of real estate’s best-kept secrets.”(3) Many investors have unlocked this previously “for institutions only” tax deferral strategy using one of the two models above. I believe that as the word gets out, the Section 721 exchange will become an increasingly popular tool amongst real estate investors to accomplish tax deferral, estate planning and diversification objectives, although it is unlikely that it will become as widely used as the 1031 exchange.
Please remember that both the IRC Section 1031 and Section 721 are complex tax codes; therefore an investor should consult his or her tax and/or legal professionals before making any investment decisions. This is not an offer to purchase securitized real estate, DST properties, REITS or any other securities. Such offers are made solely through the Private Placement Memorandum (PPM) or other appropriate offering document, such as a prospectus. Because investors’ situations and objectives vary, this material is not intended to indicate suitability for any particular investment.
- The Wall Street Journal, “Investors Broaden Reach with 1031-721 Exchange.” May 5, 2004.
- Dividend Capital Exchange – Tax-Deferred Real Estate Exchanges, September 22nd, 2008.
- Real Estate Weekly, “The benefits of selling property through an UPREIT.” April 9, 2003.
*Diversification does not guarantee profits or protect against losses.