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Everything You Should Know About 721 Exchanges (UPREITs)

CEO Khai Intela
Investors have a wide range of investment options available to them, depending on their financial goals and situation. One lesser-known alternative to the popular 1031 exchange is the 721 exchange, which offers numerous benefits. In...

Investors have a wide range of investment options available to them, depending on their financial goals and situation. One lesser-known alternative to the popular 1031 exchange is the 721 exchange, which offers numerous benefits. In this article, we will delve into the details of 721 exchanges and help you understand if this transaction might be the right fit for you.

What Is a 721 Exchange (UPREIT)?

A 721 exchange involves the exchange of real estate property for units in an operating partnership (OP). These units can then be converted into shares in a real estate investment trust (REIT). It is important to note that the property being sold must be held for investment or business purposes and cannot be personal property. These exchanges allow investors to defer capital gains taxes, diversify their investment portfolio, and gain access to professional management and liquidity.

What Is an UPREIT? What Is an UPREIT?

One of the key advantages of a 721 exchange is that it only triggers a taxable event when the investor redeems their shares. This flexibility allows investors to potentially take advantage of more favorable tax rates if they are in a lower tax bracket. Additionally, investors can earn steady dividend income from their units in the UPREIT and enjoy several other benefits associated with 721 exchanges.

Difference Between a 721 Exchange and a 1031 Exchange

While 721 exchanges and 1031 exchanges share the common goal of deferring capital gains taxes, there are several significant differences between these two transactions. Two main distinctions to note when comparing a 721 exchange vs. a 1031 exchange are:

  1. Types of assets being exchanged: In a 721 exchange, investors relinquish control of a real estate property in exchange for units of equity interest in the operating partnership. On the other hand, 1031 exchanges require investors to exchange like-kind real estate properties.

  2. Timeline: Investors undertaking a 721 exchange do not have to adhere to a specific timeline. However, those opting for a 1031 exchange must complete the process within a strict deadline. They have 45 days to identify replacement properties and 180 days from the date of the sale to purchase a property.

Main distinctions between 721 exchanges and 1031 exchanges Main distinctions between 721 exchanges and 1031 exchanges

How Does a 721 Exchange Work?

According to IRC Section 721, when a property is contributed to a partnership in exchange for an interest in the partnership, no gain or loss will be recognized from the exchange. This means that a 721 exchange does not trigger a taxable event, and the IRS will not collect taxes on any realized capital gains from the property sale.

The typical process of a 721 exchange involves the following steps:

  1. The investor contributes their relinquished property to the umbrella partnership, also known as the operating partnership (OP), of an UPREIT.
  2. In return, the property contributor receives units of interest in the umbrella partnership and becomes a unitholder.
  3. The OP retains ownership of the properties and distributes the income to the unitholders.
  4. Unitholders may choose to exchange their OP units for REIT shares, which can be easily sold.

To better understand how this transaction works, it is important to have a clear understanding of the UPREIT structure.

What Is an UPREIT?

An UPREIT allows investors to exchange their properties for units in the UPREIT. Any REIT that permits property-for-share exchanges under IRC Section 721 can be considered an UPREIT. UPREITs managers handle the administration and management of properties within the REIT's portfolio, generating revenue that is then distributed to unitholders. It's worth noting that if a unitholder liquidates their units or converts them to REIT shares, it creates a taxable event.

An UPREIT allows investors to exchange their properties for units in the UPREIT An UPREIT allows investors to exchange their properties for units in the UPREIT

What Is a DownREIT?

A DownREIT is an alternative to a REIT that allows investors to contribute property in exchange for units in the operating partnership. The key difference between an UPREIT and a DownREIT is that, with a DownREIT, investors partner with a limited partnership agreement with a REIT instead of operating under an umbrella partnership.

Investors might opt for a DownREIT when they believe that the value of their property will appreciate more than the REIT-owned properties. Instead of exchanging properties for units in the operating partnership, investors contribute their real estate to the operating partnership. The operating partnership then leases the property to the REIT, which manages the property and pays rent to the operating partnership. Investors receive a portion of the rental income proportional to their units in the operating partnership.

It is worth noting that DownREITs may not offer the same tax advantages as UPREITs if the investor fails to structure the transaction properly.

In summary, 721 exchanges offer investors an alternative to the traditional 1031 exchange, allowing them to defer capital gains taxes and enjoy other benefits such as diversification and professional management. However, it is crucial to fully understand the transaction and its implications before deciding if it is the right option for your investment strategy.

An UPREIT allows investors to exchange their properties for units in the UPREIT An UPREIT allows investors to exchange their properties for units in the UPREIT

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