721 Exchange: An Overview

Section 721 of the Internal Revenue Service’s (IRS) tax code describes a regulation that provides investors with the ability to defer capital gain taxes on the sale and exchange of commercial properties for shares in a Real Estate Investment Trust (REIT). For business owners and investors, a 721 exchange presents the opportunity to diversify real estate investments while avoiding costly property taxes that are otherwise applied to the sale of business real estate. Gain insight into 721 exchanges to take full advantage of investment ventures and increase the liquidity and diversification of your portfolio.

What is it?

A 721 exchange is also referred to as an Umbrella Partnership Real Estate Investment Trust (upREIT). These provisions allow a taxpayer to exchange property held for business or investment purposes for shares in a REIT. An REIT is a type of investment firm that purchases and invests in commercial real estate property. Instead of selling the property, the owner trades it for Umbrella or Operating Partnership (OP) units that can later be converted into REIT shares or cash. OP units and REIT shares are substantially and economically identical, and though the REIT pays dividends to holders of both, only REIT shares can be liquidated.

How does it work?

Once a 1031-exchange replacement property is held for a period of 12-24 months, the owner can then perform a 721 exchange. At this point, the property is contributed to a REIT in exchange for its value in Operating Partnership (OP) units without paying the capital gain taxes that are normally applied to the sale and depreciation of business property. After one year of owning the OP units, the investor is permitted to convert them into REIT shares or cash. If performed during the owner’s lifetime, however, this conversion is a taxable event. After the owner’s lifetime, the heirs can convert the OP units to REIT shares or cash at current market value without paying the capital gain taxes.

What are the benefits?

721 exchanges are ideal for investors looking to alleviate themselves from property management responsibilities, sell their real estate and defer taxes. This endeavor also gives property owners the ability to exchange such responsibility for an investment opportunity facilitated and managed by the expertise of real estate asset firms. Additionally, OP units are elevated up to current market value when liquidated, so a flourishing market or the success of the REIT can result in additional gain. This exchange turns an illiquid asset (real estate property) into a liquid asset (REIT shares). Accordingly, a 721 exchange is an extremely effective method to pass a liquid form of appreciated property on to successors.

Considerations of a 721 Exchange

The details and qualifications of a 721 exchange should be thoroughly considered before implementation. If an investor utilizes a 721 exchange, it’s important to understand that REIT shares are not eligible for a 1031 exchange, so reinvestment or liquidation are the only options. A 721 exchange puts an end to an asset’s lifeline with regards to tax-deferred exchanges. Additionally, as liquidation during the original owner’s lifetime is a taxable event, estate inheritance is a common use of a 721 exchange. Before executing a 721 exchange, one should also consider the current value of the REIT’s shares. If the shares are overpriced, investors can lose money on the deal as the market evens out.

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