Investing in real estate can be a lucrative way to grow your wealth, but it also comes with complexities, especially regarding taxes. For real estate investors looking to defer capital gains taxes, 721 exchanges and UPREITs (Umbrella Partnership Real Estate Investment Trusts) offer unique opportunities. This guide dives deep into what 721 exchanges are, how they work, and how UPREITs can be a strategic option for property owners.
What is a 721 Exchange?
A 721 exchange, also known as a “Section 721 Exchange,” is a tax-deferred exchange that allows property owners to contribute real estate to a partnership or real estate investment trust (REIT) without triggering a taxable event. Unlike the more commonly known 1031 exchange, which involves swapping one property for another, a 721 exchange permits a direct contribution of property in exchange for units in a partnership, specifically an UPREIT.
How a 721 Exchange Works
- Property Contribution: In a 721 exchange, an investor contributes their real estate property to an operating partnership (OP) of an UPREIT.
- Receiving Operating Partnership Units (OP Units): Instead of selling the property, the investor receives OP Units, which are similar to shares in the UPREIT.
- Tax Deferral: The exchange does not result in an immediate tax liability. Instead, taxes are deferred until the OP Units are sold.
- Conversion to REIT Shares: OP Units can later be converted into shares of the UPREIT, providing more liquidity and potential growth.
What is an UPREIT?
UPREIT stands for “Umbrella Partnership Real Estate Investment Trust.” It’s a structure that allows property owners to convert their real estate investments into a diversified, liquid portfolio without triggering an immediate capital gains tax.
Key Benefits of UPREITs
- Diversification: Instead of holding a single property, investors gain exposure to a diversified portfolio of real estate assets.
- Liquidity: OP Units can eventually be converted into shares of the REIT, making it easier to sell and cash out.
- Tax Deferral: Property owners can defer capital gains taxes until they decide to sell their OP Units or REIT shares.
721 Exchange vs. 1031 Exchange: What’s the Difference?
| Aspect | 1031 Exchange | 721 Exchange |
| Type of Exchange | Property-for-property swap | Property-for-equity (OP Units) |
| Tax Deferral | Defers capital gains taxes | Defers capital gains taxes |
| Ownership | Direct ownership of new property | Indirect ownership via OP Units |
| Liquidity | Less liquidity, tied to the property | More liquidity, can convert to REIT shares |
| Diversification | Limited to specific properties | Diversified across various assets |
Advantages of a 721 Exchange
- Tax Deferral: Just like a 1031 exchange, a 721 exchange defers capital gains taxes, allowing investors to reinvest the full value of their property.
- Increased Liquidity: Through conversion to REIT shares, investors have a more liquid investment option compared to holding direct real estate.
- Portfolio Diversification: UPREITs own multiple properties, which diversifies risk.
- Ease of Estate Planning: Transferring OP Units or REIT shares to heirs can simplify estate planning, offering potential tax benefits.
Disadvantages of a 721 Exchange
- Loss of Direct Control: Investors do not have direct control over the real estate as they would with traditional property ownership.
- Potential Tax on Conversion: If the OP Units are converted to REIT shares and sold, the sale can trigger a taxable event.
Step-by-Step Process of a 721 Exchange
- Evaluate the Property and UPREIT: Determine if the property is a good candidate for an UPREIT and if the UPREIT aligns with your investment goals.
- Consult with a Tax Professional: Understand the tax implications and benefits.
- Negotiate with the UPREIT: Submit the property to the UPREIT’s operating partnership. Once accepted, the property will be valued, and terms will be discussed.
- Transfer Property Ownership: Complete the transaction by transferring property ownership in exchange for OP Units.
- Manage Your Investment: Keep track of your OP Units and consider future opportunities to convert to REIT shares.
When Should You Consider a 721 Exchange?
A 721 exchange might be a suitable option if:
- You’re Looking for Liquidity: If you need liquidity but want to defer capital gains taxes, this exchange can be an excellent solution.
- You Want Diversification: If you’re looking to diversify your real estate investments without direct property management.
- You’re Planning for Estate Transfers: OP Units can be easier to manage in estate planning compared to physical real estate.
Risks to Be Aware Of
- Market Risk: REITs and UPREITs are subject to market volatility. If the market declines, the value of your OP Units or REIT shares could drop.
- Management Risk: Unlike directly owning real estate, you rely on the REIT’s management team to make operational decisions, which can affect your investment returns.
The Role of UPREITs in a 721 Exchange Strategy
UPREITs are essentially the vehicle that makes 721 exchanges possible. They allow property owners to transition from direct real estate ownership to holding a stake in a larger, more diversified pool of properties. For investors who wish to remain invested in real estate without the burdens of management, UPREITs offer a compelling alternative.
Tax Implications to Consider
- Deferral, Not Elimination: A 721 exchange defers taxes; it does not eliminate them. Taxes will be due when OP Units are sold.
- State Taxes: Be aware of state-specific tax regulations that might affect the outcome of your exchange.
Example of a 721 Exchange Scenario
Imagine you own a commercial building that has appreciated significantly. By contributing this building to an UPREIT, you receive OP Units instead of a traditional sale, deferring capital gains taxes. Over time, you can convert these units to shares of the REIT, providing you with greater flexibility and liquidity.
Conclusion
For real estate investors, 721 exchanges and UPREITs offer a powerful way to defer taxes, gain liquidity, and diversify portfolios. By understanding how these mechanisms work, you can make more informed decisions and strategically manage your real estate investments.
Why Choose Orvida Investment Advisors, LLC?
For investors interested in utilizing UPREITS as part of their 721 exchange strategy, Orvida Investment Advisors, LLC offers expert guidance and comprehensive planning services. As a registered investment advisor, Orvida Investment Advisors specializes in creating tailored 1031 and 721 exchange plans to align with each investor’s unique goals and financial situation.
Our Services Include:
- Personalized 1031/721 Exchange Plans: Orvida Investment Advisors develops customized 1031/721 exchange plans to help investors achieve their exchange objectives while maximizing tax deferral benefits.
- Access to High-Quality UPREITS: Orvida Investment Advisors offers a curated selection of UPREIT investment opportunities, ensuring clients have access to options that meet their specific needs.
- Expert Advice: Orvida Investment Advisors provides in-depth knowledge of UPREITS and 721 exchanges, assisting clients in navigating the complexities of these transactions.
Clients considering a 1031 or 721 exchange and want to learn more about how UPREITS can fit into their investment strategy can contact Orvida Investment Advisors, LLC to schedule an appointment to discuss your exchange goals and discover how the advisory can be of assistance.
FAQs
- What is the primary benefit of a 721 exchange?
The primary benefit is the ability to defer capital gains taxes while gaining liquidity and diversification through OP Units. - Can I convert my OP Units to cash?
Yes, you can convert OP Units into REIT shares, which can then be sold for cash, but this may trigger capital gains taxes. - Are there any restrictions on properties eligible for a 721 exchange?
Typically, properties must be investment or business properties. Consult with an advisor to verify eligibility. - How long does the 721 exchange process take?
The process can vary based on the specifics of the transaction and the UPREIT’s requirements. - Is a 721 exchange better than a 1031 exchange?
It depends on your investment goals. If you prioritize liquidity and diversification, a 721 exchange may be preferable; otherwise, a 1031 might be more suitable for direct property swaps.
