721 UPREIT Exchange: The 6 Things You Need to Know

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 offers that the 1031 exchange might not be able to fulfill. 

Before participating in a 721 UPREIT exchange, here are a few things to consider. 

What is a 721 UPREIT Exchange?

Under the umbrella of IRC Section 721, we encounter what is known as a '721 exchange'. Similar to the 1031 exchange, this allows investors to swap appreciated real estate held for investment or business uses for operating partnership units, which can then be transformed into real estate investment trust (REIT) shares. Properties facilitating a 721 exchange within the REIT are typically recognized as part of an umbrella partnership real estate investment trust (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 and 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 (i.e., the UPREIT). 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 and will likely be sold at a discount.

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.

Investors will want to check with the REIT they are investing in to ensure it is diversified. 

4. Potential Income

Cash flow through a rental property can change due to fluctuations in the market. Additionally, the property may produce less rental income than anticipated. However, many REITs pay dividends to their shareholders.

Some REIT dividends may be classified as qualified, providing tax benefits to investors.

5. Estate Planning

Investors can use a 721 exchange to pass assets to their heirs. Upon death, shares can be equally split and either held or liquidated by the trust's beneficiaries. 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 typically associated with owning real estate property. The REIT's management oversees operations and manages the portfolio of properties. 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 continues to grow in popularity. Because of the transaction structure, small individual investors can take advantage of everything the 721 UPREIT exchange offers. 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.