The 721 umbrella partnership real estate investment trust (UPREIT) exchange is a great alternative for real estate investors who want to defer capital gains taxes without having to follow a strict time frame like the 1031 exchange. The investor may also be attracted to all the other benefits that a 721 UPREIT exchange has to offer that the 1031 exchange might not be able to fulfill.
Before taking part in a 721 UPREIT exchange, here are a few things to consider.
What is a 721 UPREIT Exchange?
A 721 exchange is similar to the 1031 exchange. IRC Section 721 allows investors to exchange appreciated real estate property held for business or investment purposes for units in an operating partnership that will be converted into shares of the real estate investment trust (REIT). Any property which allows for a 721 exchange within the REIT can also be considered an UPREIT.
Below are six top benefits of the 721 UPREIT exchange.
1. Tax Advantages
When real estate is typically sold, the investor pays taxes on the capital gains realized as well as depreciation recapture. This leaves the investor with less capital for reinvestment. With the 721 exchange, the investor can avoid this hefty tax through a tax-deferred exchange of appreciated real estate for shares in an operating partnership. These shares in an operating partnership are also known as OP Units.
Capital gains are deferred until the investor sells the OP Units, converts the OP Units to REIT shares, or the contributed property is sold by the acquiring operating partnership.
2. Increased Liquidity
Real estate is typically a very illiquid asset, meaning your assets are tied up for a substantial amount of time and can’t be readily converted to cash. Transactions through a 721 exchange allow investors to potentially increase liquidity by converting some or all of the OP Units into shares of the REIT, which can then be sold. Although, this does create a taxable event.
3. Diversification
Because the 721 UPREIT exchange allows investors to purchase shares of a REIT, shareholders of a REIT don’t have their interests tied up in a single asset. A REIT generally has properties in different locations as well as possibly having industry, tenant, and asset class diversification. Diversifying among different asset classes can help investors manage potential risk.
4. Potential Income
Cash flow through a rental property can change due to fluctuations in the market and the property may produce less rental income than anticipated. However, REITs usually pay dividends to their shareholders.
5. Estate Planning
Investors can use the 721 exchange to pass their assets to their heirs. Upon death, shares can be equally split and either held or liquidated by the beneficiaries of the trust. Because these shares are passed through a trust, the beneficiaries receive a step-up in basis and can avoid capital gains taxes and depreciation recapture.
6. Passive Investing
REIT shareholders don’t need to worry about property management duties that typically are associated with owning real estate property. Managers manage the portfolio of assets of the REIT and oversee operations. Investors are not involved in any decisions but are kept informed about acquisitions, dispositions, and distributions.
With all of the potential benefits, it’s no surprise that the 721 UPREIT exchange is continuing to grow in popularity. Because of the transaction structure, small individual investors can take advantage of everything the 721 UPREIT exchange has to offer. It’s important to remember that IRC Section 721 is complex and it’s advised that investors consult with a tax professional before making investment decisions.
