Maximizing Returns: Why a 721 Exchange Might Outshine the Common 1031 Exchange in Your Specific Situation
Regarding real estate investing, taxes can often be a significant concern. Capital gains taxes, in particular, can eat into your profits and limit your ability to reinvest. Fortunately, strategies are available to help mitigate these tax burdens and maximize your returns. One such strategy is a 721 exchange, which offers unique advantages over the more common 1031 exchange. A 721 discussion can help you maximize your real estate investments and take advantage of tax-deferred exchanges.
Capital gains tax can be deferred through these two strategies. As part of a 721 exchange, investors contribute property to the operating partnership of a UPREIT. Investors contribute property in exchange for units of the umbrella partnership, which allows them to defer taxes and diversify their investments. Investing in real estate can be expanded by executing a 721 exchange across millions of properties or even billions. As a result, they can diversify their portfolio instead of focusing on only a few investments.
Investors can defer capital gains tax by exchanging one investment property for another with more excellent value. Real estate investors often use it to diversify their portfolios without incurring immediate tax liabilities. A similar property must, however, be invested in by the investor. In real estate, a like-kind property is identical to another in nature, character, or class. Property grades and quality are the same.
Like-kind properties are common in real estate. You may get a warehouse or industrial complex in exchange for the initial property. Due to their turn-key nature, Delaware Statutory Trusts (DSTs) are an attractive investment vehicle for many clients.
DSTs are legal entities that can be designed and operated in various ways. Investors receive interest and distributions based on their pro-rata share of the trust. This form of real estate ownership allows an investor to enjoy the perks of a real estate allocation without the headaches of direct real estate ownership, like property upkeep and tenants. DSTs can hold one or multiple properties to offer additional exposure for investors and a ready-made solution for a 1031 exchange.
In contrast, investors relinquish control over the property’s management and need more liquidity, making cashing out difficult. Nevertheless, some investors may prefer a 721 UPREIT over a DST because it offers more liquidity control. The investor can use this investment tool to fund their child’s education or a significant life event, for example, because it provides real estate exposure without the illiquidity of a DST.
Unlike DSTs, which require the entire asset to be sold before taxes can be calculated, REIT shares allow the investor to convert operating partnership units into REIT shares and liquidate them as needed.
Liquidity isn’t guaranteed with non-traded REITs since redemption plans vary, so liquidity isn’t guaranteed. Additionally, liquidity (opens in new tab) can be further restricted because fund managers often decide whether an investor can sell shares.
Older investors who have completed DST 1031 exchanges throughout their life could be attracted to moving into 721 UPREIT exchanges. Perhaps they are tired of meeting the exchange process every five to 10 years and are ready to prepare for a completely hands-off experience.
Exchanges will not be possible after completing a 721 exchange. UPREIT money movements will be taxable in the future. In other words, if you decide to convert your OP units into REIT shares for potential liquidity, that would be a taxable event. As a result, once the assets are passed on to your heirs, you can benefit from their appreciation. To participate in realized appreciation, investors may prefer a DST.
If investors are not interested in further diversification, they choose DSTs over UPREITs. After conducting proper due diligence on a particular DST asset, you may believe in it if you have invested in multifamily apartment complexes for a long time. You may disagree with the REIT’s acquisition strategy and want control over the asset or assets you invest in.
In general, REITs are open-ended investment pools whose assets are deployed entirely at the managers’ discretion and whose investment objectives and strategies may change over time.
In addition, both 721 UPREITs and DST 1031 exchanges offer investors the option of eliminating their tax liability upon passing their investments on to their heirs. A step-up in cost basis is awarded to the investor’s heirs when the asset is transferred to them after the investor passes away. Depreciation recapture and capital gains tax liabilities on the real estate do not pass on to the heirs. In making your decision, consider the type of investment you will pass on to your heirs.
Investors should choose between a 721 UPREIT and a 1031 exchange based on their specific goals and circumstances. The 721 UPREIT may be preferable for those wanting more liquidity and diversification control. Alternatively, a 1031 exchange allows investors to continue reallocating their real estate portfolio without incurring an immediate tax liability, even though it offers fewer options for diversification.
