Pros & Cons of Deferring Taxes With a 721 Exchange

721 exchanges, or UPREITs, can be an excellent tax mitigation strategy for real estate investors who desire instant diversification to continue growing their wealth without direct management, though they’re not always perfect for everyone.

Understanding 721 Exchanges

Real estate investors know two key things: first, investing in real estate, while not without risk, is one of the best ways to build wealth over time; and second, taxes, especially capital gains taxes, can make it harder to grow that wealth.

When an investor sells a property that has increased in value, they have to pay taxes on the profit, usually around 20%. This can really slow down how quickly their wealth grows. For example, if you sell a property for $2 million that you bought for $1.5 million five years ago, you make a $500,000 profit. But, you have to pay $100,000 in taxes on that profit, which is a lot of money lost.

Because of this, investors look for ways to delay or avoid paying these taxes while staying invested in real estate. One common way to do this is through a 1031 exchange, where investors can swap one property for another without paying taxes right away.

However, there is another method that some savvy investors use: the 721 exchange, or UPREIT.

How a 721 Exchange Works

With a 721 exchange, investors can defer taxes by contributing their property to a partnership in exchange for partnership interests. These deals usually involve real estate investment trusts (REITs), which use an umbrella partnership real estate investment trust (UPREIT) structure.

In a UPREIT structure, investors swap their property for operating partnership units (OP units). These units are held for a period, usually 12-24 months, and offer benefits similar to holding REIT shares, including dividend-like payments. The capital gains taxes are deferred until the OP units are converted into permanent REIT shares, leading to a diversified, high-quality investment that pays regular dividends.

This is similar to a 1031 exchange into a REIT, which isn’t usually allowed because a REIT isn’t considered a “like-kind” property. Investors start with appreciated real estate, perform a tax-free transaction, and end up with REIT shares, which represent a diversified real estate investment portfolio.

Disadvantages of a 721 Exchange

First, it’s important to understand the potential drawbacks of a 721:

Potential Capital Loss: REIT share prices can fluctuate, leading to potential losses.
Legacy Assets: Existing properties in the REIT’s portfolio may underperform, affecting overall returns.
Involuntary Capital Gains: Decisions by REIT management can trigger taxable capital gains for investors.
Loss of Flexibility: A 721 exchange is often a final step for investors who don’t want to do more 1031 exchanges. Once converted to REIT shares, you can’t switch back to real estate.

Advantages of a 721 Exchange

Conversely, there are several benefits to 721 exchanges for real estate investors:

Diversification: Investors can move from owning a single property to holding a diversified portfolio of investment-grade properties across various locations, industries, and asset classes.
Liquidity: REIT shares, often publicly traded, can be easily sold if needed.
Estate Planning: REIT shares are easier to divide and pass on after the owner’s death, helping with estate planning.
Regulatory Stability: Unlike 1031 exchanges, which face increasing scrutiny, 721 exchanges have remained largely unchanged for 50 years, providing long-term security.
Passive Investing: REIT shareholders benefit from professional management, eliminating the need to manage properties directly.
Passive Income: REITs typically pay high dividends, averaging 4% or more, providing a steady income.
Capital Appreciation: REITs aim for capital growth, with share prices reflecting real estate market trends.
Tax Deferral: Deferring a 20% capital gains tax (plus potential state taxes) for a year or longer allows investors to keep more of their money.

For investors who prefer direct ownership and active management of properties, UPREITs might not be the best choice. However, for those who want to stay in real estate without the day-to-day management or who want to avoid ongoing 1031 exchanges, a 721 exchange can be a good option. Additionally, 721 exchanges can help eliminate tax liabilities when passing investments to heirs, as the heirs receive a step-up in cost basis to the fair market value at the time of inheritance, avoiding depreciation recapture or capital gains tax liabilities.