How to Defer Real Estate Taxes with a 721 Exchange

Real estate investors have long known the benefits of a 1031 exchange, which allows sellers of real estate assets to defer capital gains taxes by reinvesting their sale proceeds into a “like-kind property.”

Another provision in the U.S. tax code also allows for tax-deferred sales, with the added benefits of diversification and perhaps simpler estate planning. In a 721 exchange, instead of reinvesting sale proceeds into another property, the investor can defer taxes by contributing their property to a partnership in exchange for interests in the partnership. Typically, the seller of the property will conduct the 721 exchange with a partnership that is part of an “UPREIT” structure, where the partnership is an operating partnership that is a subsidiary of a real estate investment trust (REIT).

“The 721 structure seems to be a very appealing solution for investors who own real estate, and a lot of them don't know that it's an option,” said Rich Williams, director at Hines Securities. Hines is a sponsor in certain private offerings, and this article does not describe any such offering.

It may sound simple, but a few more steps are required to complete a 721 exchange, which may take at least two years to execute. Here’s more about these opportunities that are gaining more visibility.

A 721 exchange, often referred to as a "like-kind" exchange under Section 721 of the Internal Revenue Code, involves the tax-deferred exchange of property for interests in an operating partnership or a similar entity.

This exchange allows investors the potential to diversify their investments without incurring immediate tax consequences. However, it’s important to note that if or when the investor eventually sells their interest in the operating partnership or REIT, capital gains taxes may apply (more on this later).

Accredited investors, who according to the Securities and Exchange Commission have a net worth of at least $1 million, excluding their primary residence; or an income of at least $200,000 individually or $300,000 in combination with their spouse or partner in each of the prior two years, with reasonable expectations of the same for the current year.

For non-institutional investors, there is often a two-step process to completing a 721 exchange, because most REITs aren’t in the market for individual, non-institutional properties from independent investors.

Instead of selling directly to the REIT, these investors can find another buyer for their property, and then invest the proceeds in a Delaware Statutory Trust (DST) via a 1031 exchange. The DST pools together investors buying fractional ownership in large, institutional-grade properties that might otherwise be inaccessible (for example, a fully leased trophy apartment tower valued at $100 million). When the DST raises enough funds to acquire said property, a two-year holding period begins.

During these two years, investors in the DST typically earn distributions at a conservative rate. At the end of the two years, a REIT has the option to acquire the DST’s property within a certain period, at which point the DST investors would exchange their DST interests for operating partnership units, which typically receive cash distributions and hopefully rise in value over time.

“Assuming the REIT exercises its option to acquire the property, it may potentially give investors diversification benefits while continuing their tax deferral,” Williams said.

There are several potential benefits to a 721 exchange, as an alternative, or as a complementary solution to a 1031 exchange:

• Diversification. Unlike a 1031 exchange, when you are exchanging a single property for another, REITs can hold properties across several different asset classes, or at least across a wide geographic footprint within a single asset class.
• Liquidity. This comes with the caveat that there is a two-year holding period in the DST required by the Internal Revenue Service, and when an investor sells its interest in the operating partnership or the REIT to obtain liquidity, it likely triggers a taxable liability. Further, if the operating partnership units are exchanged for REIT shares rather than cash, it is important to note that some REIT shares are not publicly traded, which might further limit liquidity. However, operating partnership units and REIT shares can still provide passive income for 721 investors. There is also the potential for modest cash distributions paid out by the DST during the two-year holding period. It’s also easier to sell shares in a REIT than to sell a property.
• Tax Deferral. A 721 exchange allows investors to defer capital gains taxes that would otherwise be owed following a conventional real estate sale.
• Simple Estate Planning. One property may be difficult to sell or divide interests in when passing assets on to multiple heirs. REIT and operating partnership interests, however, can easily be split and either held or sold by beneficiaries in a decedent’s trust. Deferred capital gains cannot be inherited, so heirs will receive a step-up in cost basis in their shares, and only pay capital gains when they sell shares for a gain, not when they inherit.

“It is an extremely powerful estate planning and generational wealth transfer solution for a lot of investment property owners,” Williams said.

There are a few things to consider before pursuing a 721 exchange, however. Potential drawbacks include:

• Fees. 721 investors need to find a qualified intermediary and invest through a financial advisor, both of which will charge a fee. Then, there is the management fee the REIT charges, which usually ranges from 1 to 2 percent of equity invested.
• Time. As noted above, there will be a minimum two-year holding period within the DST, during which time investors generally could expect to earn only modest cash distributions relative to the returns they might realize during that period if they had sold the property via a 1031 exchange or sold the property and invested the sale proceeds in more lucrative investment opportunities. There is also the risk that the property held in the DST falters during this period.
• Limited Future Options. Unlike in a 1031 exchange, where an investor can keep swapping like-kind properties, a 721 investor cannot sell their operating partnership units to the REIT to get liquidity in their lifetime without incurring capital gains taxes on their original sale. This makes 721 exchanges most appealing as an estate planning tool.

“In a standalone 1031 exchange, the investment is in the single property, and once that property is sold, then the investor has the option to do another 1031 exchange, and you could essentially “swap till you drop,” as it's referred to. With the 721, that's not the case,” Williams said. “If the 721 is exercised investors can't go from the diversified portfolio back into a single asset. The portfolio that they're investing into is the last stop until the client either decides to liquidate their position or hold until passing.”

There are a few key professionals an interested investor should contact to start a 721 exchange:

• Financial Adviser. In most cases, a financial adviser will find 721 exchange opportunities for the investor.
• Certified Public Accountant or Tax Adviser. With this being a tax strategy, it’s paramount to have a CPA or other tax adviser involved to make sure the process is done correctly.
• Qualified Intermediary. Investors should contact the qualified intermediary before selling their original property so that the proceeds roll directly to the intermediary. If proceeds from the sale hit the investor’s bank account, the sale becomes a taxable event.