Investors selling property can use various strategies to defer capital gains taxes on real estate investments. One of the less-known strategies is the 721 exchange, also known as the umbrella partnership real estate investment trust (UPREIT).
Although the more popular 1031 exchange is also an option, a 721 exchange offers unique advantages that investors should consider. Choosing between strategies to defer real estate capital gains taxes depends on an investor’s goals.
In a 721 exchange, a shareholder adds their property to the operating partnership (OP) of a UPREIT. In exchange, they receive units of interest in the holding company. A 721 exchange offers tax deferral and the potential for variety across assets worth millions or billions.
Through a 721 exchange, investors can expand their real estate holdings beyond one or two properties. The 1031 exchange rules, on the other hand, let investors postpone paying capital gains taxes. By exchanging one (or more) real estate investment properties for ones with an equivalent or higher value.
While 1031 exchanges are often used by investors looking to expand their real estate inventory without incurring an immediate tax liability, the investor must reinvest in a like-kind investment property. Like-kind property refers to a property with the same character or nature or that is part of the same class, with the property’s grade or quality not mattering.
Most real estate properties will be like-kind to other properties, but investors should consider using a Delaware Statutory Trust (DST) as an investment vehicle, as they offer a turn-key solution that qualifies for 1031 exchanges. A DST is a legal entity with an easy approach to the entity’s design and operation, allowing investors to enjoy the benefits of real estate sharing without the headaches of direct real estate ownership, such as property upkeep and tenants.
However, investors yield a level of control around the management of the property and have limited liquidity, making it difficult to cash out of the DST. Some investors may prefer a 721 UPREIT to a DST because it provides greater liquidity control.
This investment tool, for example, may benefit an investor looking to fund their child’s continuing education or a major life event because it provides real estate risk without the lack of cash of a DST. This allows the investor to convert operating partnership units into REIT shares and liquidate them as needed. A 721 exchange provides more flexibility in managing tax liability and liquidity than DSTs, which mandate selling the entire asset.
However, once an investor achieves a 721 exchange, they are no longer able to continue exchanging. Any money movement from the UPREIT will be a taxable event going forward. Which means that converting OP units to REIT shares for potential liquidity will be a taxable event. Investors who want to keep exchanging in order to participate in realized appreciation may prefer a DST. Finally, the investor’s specific goals and circumstances influence the choice between a 721 UPREIT and a 1031 exchange.
The investor’s unique objectives and situation will ultimately influence whether to choose a 1031 exchange or a 721 UPREIT. If you want more diversification and better liquidity control, a 721 UPREIT might be the better option. A 1031 exchange limits reinvestment options to like-kind investment properties. While a 721 exchange offers similar benefits without such limitations for deferring real estate capital gains taxes.
Investors should also consider what type of investment they want to pass on to their heirs, as both 721 UPREITs and DST 1031 exchanges offer an option for investors to eliminate their tax liability when they pass the investments on to their heirs.
It’s important to remember tax laws are incredibly complex, and our short blogs cannot cover all the details of rules. This is why it’s crucial to find an experienced, highly qualified tax expert to assist you with your specific situation. Trying to direct the tax code on your own can lead to missed opportunities and possible risks.
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721 Exchange for Deferring Real Estate Capital ...
[…] For investors looking to sell a real estate investment property and defer capital gains taxes, there are several strategies available to them. One of the less-known strategies is the 721 exchange, also known as the umbrella partnership real estate investment trust (UPREIT). […]