Can You Do a 1031 Exchange into a REIT with Section 721 Exchange?

CEO Khai Intela
Reasons for the growing popularity of UPREITs today include their ability to overcome a common hurdle faced by investors - specific acquisition criteria set by most REITs. In many cases, the relinquished properties of investors...

Real Estate to REIT Exchange Comparison

Reasons for the growing popularity of UPREITs today include their ability to overcome a common hurdle faced by investors - specific acquisition criteria set by most REITs. In many cases, the relinquished properties of investors do not align with the criteria of the REITs they want to invest in.

Another advantage of exchanging into REITs is the easier avoidance of taxable boot, which is discussed in more detail in our articles on partial 1031 exchanges and taking cash out of a 1031 exchange. UPREITs address this issue by acquiring fractional real property interests that meet the targeted REIT criteria. To avoid IRS challenges, these fractional investments are typically held for at least 24 months, during which regular dividends are paid. Afterward, the exchange funds are reinvested in REIT shares or units.

When it comes to REIT 1031 exchanges, the most popular type is acquiring a share in a Delaware Statutory Trust. To learn more about this, be sure to check out our guide to Delaware Statutory Trust (DST) 1031 Exchanges.

What Is a 721 Tax Deferred Exchange?

A section 721 exchange, which involves exchanging real estate for REIT participation, is gaining popularity alongside §1031 and UPREIT exchanges. Here's a definition of a 721 exchange:

A 721 exchange is a type of tax-deferred exchange that allows investors to exchange rental or investment property for real estate investment trust (REIT) interests. This exchange enables investors to make tax-free exchanges without the need to find replacement properties.

In a 721 exchange, investment owners contribute their real estate property to REITs in exchange for shares. Alternatively, units in Operating Partnerships (OPs) may be issued initially instead of shares. OPs are independent intermediaries, often owned by REIT sponsors, that aggregate real estate property and exchange funds, as shown in the chart. At the discretion of the Partnership, these assets may be retained for a period before being rolled into a REIT tax-free exchange. It's important to note that REITs are a property to security exchange, so there is no requirement to hold the property for two years like in a traditional exchange.

REITs are trusts that own property portfolios such as office buildings, hotels, and shopping malls. Their income is derived from leasing these properties to tenants, collecting rent, and earning mortgage interest by lending capital to land development companies. REITs involve various components and players, each with their own roles and responsibilities. These include unitholders (investors), trustees (property owners), REIT managers, property managers, and sponsors. All participants must adhere to the rules for the exchange to succeed and retain its benefits.

721 Exchange Rules

Now, let's delve into the process of conducting a section 721 exchange. While not as complex as an UPREIT, it can still be daunting, often requiring professional assistance.

The IRS Section 721 allows real estate property investors to contribute their properties to REITs in exchange for REIT shares or Operating Partnership units (PO units). These OP units offer all the economic benefits of a REIT, including distributions of operating income. Neither of these exchanges triggers capital gains or depreciation recapture taxes. Furthermore, the units can be converted into shares of the issuing REIT at a later stage if desired. However, it is crucial to adhere to the following IRS exchange rules to avoid the exchange failing or taxes being imposed:

  • Once exercised, the process cannot be reversed, and investors cannot regain ownership of the relinquished properties.
  • Even if the real estate has already been sold, investors may still contribute exchange funds for REIT shares directly or initially to OPs for units.
  • The timing of when OP unitholders' units are rolled into REIT shares is not controlled by the investors, but the exchange remains tax-free.
  • Investors may sell shares in accordance with the REITs' redemption program or, if publicly traded, they can be sold like stocks.
  • Investors retain control over the timing and quantity of any share sales.
  • Investors may liquidate the REIT shares in accordance with the REIT's Trust Deed, selling them similar to common stocks.
  • As long as real properties remain in the REIT or with an OP, capital gains and depreciation recapture taxes are deferred.
  • After receiving REIT shares or OP units, taxes cannot be deferred again in any future transactions.
  • If REIT interests are sold and proceeds are returned to investors, any capital gains or losses must be recognized.

Section 721 Exchange Benefits

Investors are increasingly utilizing IRS Section 721 exchanges for their real estate properties, as they offer various benefits such as tax deferral, wealth growth, portfolio diversification, and estate planning opportunities. Even if real estate has already been sold, the proceeds can still be used as exchange funds directly into a REIT or interim Operating Partnership. Replacement properties are not required for this type of exchange.

There are several other advantages to exchanging real property for REITs:

  • Investors have control over when and how many REIT shares they choose to sell, which determines whether taxes will be imposed. Capital gains and depreciation recapture taxes typically range from 20-40% of realized gains. Timing plays a crucial role in deciding whether to defer and reinvest exchange funds or sell and report gains when offsetting capital losses are available.
  • REITs typically provide steady income through regular dividend payments. Holding a diversified portfolio helps minimize reliance on a single asset for both cash flow and appreciation.
  • Real estate property appreciation historically outperforms inflation, making REIT shares a good option for wealth building.
  • Investors enjoy liquidity, as they can buy and sell REIT properties similar to common stocks.
  • Fractional property investments make it more affordable for small investors to acquire an interest in institutional-grade real estate. Through tenants in common, large capital investments are no longer necessary.
  • REITs offer enhanced diversification, as they typically hold portfolios with various tenants, property types, and locations.
  • Transparency is another advantage, as investors have access to quarterly financial reports of REITs. Most REITs are subject to government regulations, compliance audits, and oversight.
  • REITs are growth-oriented entities that often have sponsor-aided support. Investment specialists continuously make strategic acquisitions on behalf of Operating Partnerships.
  • REIT property managers handle day-to-day operations, providing time and stress savings for investors. They are accountable to Trustees and REIT managers, all of whom have fiduciary responsibilities toward investors.
  • Estate planning benefits are significant, as dividing physical real property among heirs can be complicated. REIT shares, on the other hand, can be easily divided or held in trusts. Heirs receive a stepped-up basis and can avoid all capital gains and depreciation recapture taxes deferred by the estate.

However, it is important to note that REITs also carry risks. Unlike §1031 exchanges, REIT shares and operating partnership units cannot be exchanged back for ownership in real estate properties over time. As with any commercial property investment, some losses may not be foreseeable.

It is evident that the tax issues involved in these exchanges are complex. Seeking professional guidance can help investors optimize benefits and mitigate risks.

How to Ensure Your Exchange Is Legal and Safe?

If your exchange from real estate to REIT shares involves a section 1031 exchange, it must also involve a qualified intermediary. A qualified intermediary, such as those available through PropertyCashin, is a professional, competent, and experienced 1031 exchange company that ensures the procedure is completed legally and in compliance with all IRS rules. PropertyCashin is an all-in-one platform for commercial real estate investors, providing connections to top-rated 1031 exchange firms across the USA. Fill out the form below to get connected with the best professionals and have your exchange processed safely and effectively.