Tax-deferred solutions are available to real estate investors in the United States. The most well-known tax-deferred solution is the 1031 exchange. However, with today’s challenging market, many real estate investors are now turning to 721 exchanges.
In this article, we will outline the difference between a 1031 exchange and 721 exchange, as well as the requirements, benefits, and risks of a 721 exchange.
A 1031 exchange is a like-kind exchange that allows properties of like-kind to be exchanged so long as they are of the “same nature or character, even if they differ in grade or quality.”
Per the Internal Revenue Service (IRS), “Real properties generally are of like-kind, regardless of whether they’re improved or unimproved. For example, an apartment building would generally be like-kind to another apartment building. However, real property in the United States is not like-kind to real property outside the United States.”
Generally, real estate investors are not permitted to exchange into a REIT since shareholders of a REIT own shares rather than interest in the real estate. However, section 721 provides investors a legal loophole to this challenge, enabling them to trade their real property into shares of a REIT while deferring capital gains tax.
The IRS explains that a 721 exchange, per section 721, “… no gain or loss shall be recognized to a partnership or to any of its partners in the case of a contribution of property to the partnership in exchange for an interest in the partnership.”
To exchange, investors must trade into an UPREIT, or umbrella partnership real estate investment trust. These trusts are uniquely structured to qualify under Internal Revenue Code section 721.
Completing a 721 exchange involves a unique process, whereas a REIT acquires an investor’s property in exchange for ownership shares. The property generally must meet the acquisition criteria of the REIT, although this is not a legal requirement. For example, a REIT may focus its portfolio on multi-family properties in the Southeast and restrict acquisitions to these assets.
In addition to real property, other 1031 qualified investments are suitable for a 721 exchange, including fractional ownership in a DST.
A DST, or Delaware Statutory Trust, is a legally recognized real estate investment trust in which investors can purchase a fractional ownership interest in real estate – they are then considered passive investors in the real estate. DSTs are one of the few co-ownership real estate investment structures that qualify for a 1031 exchange. Investors interested in trading out of their DST can leverage a 721 exchange.
In fact, many DSTs are created with the intent to transition into a REIT. In this scenario, retail investors access a 721 exchange by exchanging their rental properties into DSTs intended to change into an UPREIT. Generally, these DSTs structure their holding periods, debt, fees, and asset purchases to fit into their existing REITs or proposed REITs that they intend to offer. Investors typically have two to three months of notification of the sale or transfer.
Once the DST transitions into a REIT, sponsors may provide DST investors the optionality to select a 721 exchange, 1031 exchange, or cash out. If they opt to complete a 1031 exchange, they must exchange per IRC section 1031. If they cash out, they will be responsible for the tax consequences, including paying capital gains.
To qualify for a 721 exchange, investors are typically advised to only trade real property, including fractional ownership in a DST, after holding the real estate for at least two years. This longer hold period will show that the property was held for investment purposes and is less likely to face possible tax consequences.
In some cases, especially when properties are held under the two-year threshold, the IRS could assume that the property was acquired to buy and sell for a profit, disqualifying the exchange from the tax-deferred process.
A 721 exchange attracts investors looking for a tax-deferral solution that improves portfolio diversification while offering similar benefits as traditional real estate investing.
● Tax Deferred Exchange: The most prevalent benefit that a 721 exchange provides is that it permits investors to trade their real estate while deferring capital gains. This results in more capital invested and the potential for higher returns.
● Greater Diversification: A 721 exchange offers investors access to greater diversification by investing in a REIT. REITs typically have hundreds of properties in its portfolio, offering the possibility of more stability for shareholders during economic volatility. This may be advantageous compared to investors who own individual assets or even ownership interests in DSTs.
● Professional Management: UPREITs are professionally managed by individuals with experience in the real estate sector. They can provide insight into how to strive to accommodate changing markets, trends that many real estate investors cannot respond to.
● Laddered Financing: Unlike individual ownership, UPREITs leverage laddered financing, providing potential stability through economic cycles. Laddered financing relies upon multiple lending sources, varying in rates and maturity dates.
● Increased Liquidity Potential: Most UPREITs are not publicly traded REITs. Generally, these trusts are structured to allow investors to sell their shares at specific intervals, providing more potential for liquidity than DSTs and individual property ownership. However, investors typically must invest for at least one year before selling their shares. Upon sale, investors should be conscious of what tax implications they may face. Additionally, the resale of shares is not guaranteed.
● Better Growth: REITs have more controllable variables that may drive value. For example, unlike DSTs, REITs can trade properties held within the trust. Therefore, they can exchange lower-performing assets to seek tobetter meet the pro-forma returns outlined for investors.
While there are various benefits of a 721 exchange, risks also exist. Investors considering a 721 exchange must understand that following a 721 exchange, their investment no longer qualifies for a 1031 exchange. As a result, investors must either remain invested or pay capital gains upon liquidation. This differs from a traditional 1031 exchange, whereas investors can continue to exchange so long as the properties and the exchange meet the guidelines outlined by section 1031.
Furthermore, especially when DSTs are structured to transition to an UPREIT, investors should review the experience of its sponsors. DSTs offering 721 options may not have a REIT yet established and may have minimal or no experience in the sector.
Lastly, investors considering a 721 exchange must take caution and understand that there is no guarantee. At the time of acquisition, the REIT must want the investor’s property or DST for their portfolio. If the investor’s property becomes undesirable to the REIT, the REIT has no obligation to buy it at the previously negotiated price; they’re only required to offer fair market value (FMV).
If conducted correctly, a 721 exchange could provide strong benefits. However, if the guidelines of section 721 are not adhered, heavy tax consequences could be incurred by the investor.
Therefore, before completing any transaction, it’s well advised to seek professional advice regarding your exchange.
Not an offer to buy, nor a solicitation to sell securities. All investing involves risk of loss of some or all principal invested. Past performance is not indicative of future results. Speak to your finance and/or tax professional prior to investing. Any information provided is for informational purposes only.
Securities offered through Emerson Equity LLC Member: FINRA/SIPC. Only available in states where Emerson Equity LLC is registered. Emerson Equity LLC is not affiliated with any other entities identified in this communication.
· There’s no guarantee any strategy will be successful or achieve investment objectives;
· All real estate investments have the potential to lose value during the life of the investments;
· The income stream and depreciation schedule for any investment property may affect the property owner’s income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities;
· All financed real estate investments have potential for foreclosure;
· These 1031 exchanges are offered through private placement offerings and are illiquid securities. There is no secondary market for these investments.
· If a property unexpectedly loses tenants or sustains substantial damage, there is potential for suspension of cash flow distributions;
· Costs associated with the transaction may impact investors’ returns and may outweigh the tax benefits
Perch Financial LLC and Emerson Equity LLC do not provide legal or tax advice. Securities offered through Emerson Equity LLC Member FINRA/SIPC and MSRB registered. Emerson Equity LLC is unaffiliated with any entity herein. 1031 Risk Disclosure:
No offer to buy or sell securities is being made. Such offers may only be made to qualified accredited investors via private placement memorandum. Risks detailed in a private placement memorandum should be carefully reviewed, understood, and considered before making such an investment. Prospective strategies and products used in any tax advantaged investment planning should be reviewed independently with your tax and legal advisors. Changes to the tax code and other regulatory revisions could have a negative impact upon strategies developed and recommendations made. Past performance and/or forward-looking statements are never an assurance of future results.
Many of the investments offered will be only available to those investors meeting the definition of an Accredited Investor under SEC Rule 501(A) and offered as Regulation D private placement securities via a Private Placement Memorandum (“PPM”). Prospective investors must receive, read, and understand all the risks associated with buying private placement securities. Investments are not guaranteed or FDIC insured and risks may include but are not limited to illiquidity, no guarantee of income or guarantee that all tax advantages or objectives will be met and complete loss of principal investment could occur.
Risk Disclosure: Alternative investment products, including real estate investments, notes & debentures, hedge funds and private equity, involve a high degree of risk, often engage in leveraging and other speculative investment practices that may increase the risk of investment loss, can be highly illiquid, are not required to provide periodic pricing or valuation information to investors, may involve complex tax structures and delays in distributing important tax information, are not subject to the same regulatory requirements as mutual funds, often charge high fees which may offset any trading profits, and in many cases the underlying investments are not transparent and are known only to the investment manager. Alternative investment performance can be volatile. An investor could lose all or a substantial amount of his or her investment. Often, alternative investment fund and account managers have total trading authority over their funds or accounts; the use of a single advisor applying generally similar trading programs could mean lack of diversification and, consequently, higher risk. There is often no secondary market for an investor's interest in alternative investments, and none is expected to develop. There may be restrictions on transferring interests in any alternative investment. Alternative investment products often execute a substantial portion of their trades on non-U.S. exchanges. Investing in foreign markets may entail risks that differ from those associated with investments in U.S. markets. Additionally, alternative investments often entail commodity trading, which involves substantial risk of loss.
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