Understanding 721 Exchanges (UPREIT)
A Tax-Advantaged Pathway to Real Estate Diversification
A 721 Exchange, also known as a 721 UPREIT Exchange, provides real estate investors with a powerful tool to transition their investments into a Real Estate Investment Trust (REIT) in a tax-deferred manner.
This advanced investment strategy enables investors to access professionally managed, diversified real estate portfolios while deferring capital gains taxes. Here’s a closer look at what 721 Exchanges are, how they work, and their potential benefits.
What Is a 721 Exchange?
Section 721 of the Internal Revenue Code allows real estate owners to contribute property to a REIT’s operating partnership through an Umbrella Partnership Real Estate Investment Trust (UPREIT) structure. Unlike a traditional 1031 Exchange, which focuses on “like-kind” property swaps, a 721 Exchange enables investors to transition from direct property ownership or Delaware statutory trusts (DSTs) into an interest in a REIT operating partnership.
How Does a 721 Exchange Work?
The process typically has two phases:
- Sell Relinquished Property: Investors sell their original property and direct the proceeds to a Qualified Intermediary (QI). A QI is a neutral third party required in a 1031 Exchange to facilitate the transaction and ensure compliance with IRS regulations. The QI holds the funds from the sale to prevent the investor from taking constructive receipt, which would disqualify the exchange for tax deferral purposes
- Acquire DST Interests: The proceeds are released by the QI and reinvested in a DST, serving as the replacement property in a 1031 Exchange
- Transition to REIT Operating Units: After holding DST interests for a period, typically two years, the REIT may purchase the DST-held property at fair market value. In return, the investor receives Operating Partnership Units (OP Units) in the REIT
- Ownership in a REIT Portfolio: These units grant investors a stake in the REIT’s diversified real estate portfolio
Forced vs. Optional 721 Exchanges
Under a forced 721 Exchange, investors must exchange their DST interests for REIT shares under specific circumstances, often during a liquidity event. While this offers immediate diversification and professional management, the timing may not align with the investor’s financial strategy, and it may expose the investor to the market–and its volatility–if the REIT’s shares are traded.
Under an optional 721 Exchange, investors can convert DST interests into REIT shares at a time that suits their goals. This provides flexibility to align the exchange with market conditions and the investor’s financial planning needs.
Understand the Quality of the REIT
Before committing to a 721 Exchange, investors should evaluate the REIT’s financial health, the quality of its portfolio and the skill and track record of its management team.
Don't Go It Alone
The complexities of 721 Exchanges make professional guidance essential. Experts in alternative investments and tax-advantaged strategies, like DSTs 1031 Investments, can help navigate the 721 Exchange process, explain the benefits and risks, and evaluate available investments.
Benefits of a 721 Exchange
Engaging in a 721 Exchange has several potential benefits:
-
TAX DEFERRAL
Continues the capital gains tax deferment initiated in a 1031 Exchange -
DIVERSIFICATION
Access to a professionally managed portfolio of institutional-grade properties across various sectors and geographies -
INCREASED LIQUIDITY
REIT shares often come with redemption programs, enhancing liquidity compared to traditional real estate ownership or DST investments -
ESTATE PLANNING BENEFITS
REIT shares can be divided among beneficiaries at a stepped-up cost basis, providing permanent tax deferral on gains and depreciation recapture