Understanding 1031 and 721 Exchanges

Which Strategy is Right for Your Clients?

For accredited investors, mastering the nuances of tax-advantaged real estate investment strategies is key to optimizing wealth-building opportunities. Among the most effective tools are the 1031 and 721 exchanges, each offering significant tax-deferral benefits that can potentially enhance long-term financial growth.

These strategies cater to different investment goals while deferring capital gains tax implications. By understanding both 1031 and 721 exchanges, investors can make informed decisions that align with their financial objectives and potentially benefit from passive, diversified real estate investments.

1031 Exchange

Purpose:

A 1031 exchange allows real estate investors to defer capital gains taxes by reinvesting the proceeds from the sale of an investment property into a like-kind property.

Process:

• Identification Period: Investors have 45 days after selling the original (relinquished) property to identify potential replacement properties.
• Exchange Period: The replacement property purchase must be completed within 180 days from the date of sale of the original (relinquished) property.
• It is crucial to engage a Qualified Intermediary (QI) to manage the exchange process between the seller and the buyer. QI holds the proceeds from the sale and ensures that the seller doesn’t receive the funds directly as it would trigger a taxable event.
  
  

Benefits:

• Tax Deferral: Investors can defer capital gains taxes indefinitely by continuously reinvesting in like-kind properties.
• Estate Planning: Investment properties can be passed to heirs with a step-up in basis, potentially eliminating capital gains tax on inheritance.

Common Usage:

The 1031 exchange is ideal for investors who want to defer taxes, while also maintaining ownership in a variety of potential income-producing properties to leverage market trends and diversify their portfolios.

721 Exchange

Purpose:

A 721 exchange enables investors to contribute property to a real estate investment trust’s (REIT) operating partnership in exchange for operating partnership (OP) units, deferring capital gains taxes. A 721 exchange also may be structured through the exchange of Delaware statutory trust (DST) interests for OP units if an operating partnership wants to purchase, or has an option to purchase, the property owned by such DST. DST interests are the structure of choice for a 1031 like-kind exchange and qualify as real property for exchange purposes.

Process:

• Investors exchange DST interests or property for OP units in the REIT’s operating partnership.
• Depending on the structure of the OP, OP units may be redeemed after a lockout period, which is a taxable event.
  
  

Benefits:

• Diversification: Investors own part of a larger portfolio, spreading risk across multiple properties.
• Liquidity: OP units potentially provide liquidity as they may be redeemable after a specified holding period.

Common Usage:

This exchange is suitable for investors seeking passive income, diversification, and potential liquidity without the responsibilities of direct property ownership.

Combining 1031 and 721 Exchanges

Investors can use a combination of 1031 and 721 exchanges to maximize tax-deferral benefits and achieve diversification. Here’s how:

1. Initial 1031 Exchange: Investors can defer taxes by investing in a DST through a 1031 exchange.

2. Subsequent 721 Exchange: Later, since DST interests qualify as real property under a 721 exchange, a REIT’s operating partnership may purchase the property owned by the DST and offer OP units to the DST investors in exchange for their DST interests. This further defers taxes and provides the benefits of diversification and potential liquidity.

As sophisticated real estate transactions, understanding the differences between the 1031 and 721 exchanges is essential for financial professionals advising accredited investors. Each strategy offers unique advantages that can be leveraged to meet various investment goals and tax planning needs. 

By effectively using these real estate solutions, investors may enhance portfolio diversification, minimize portfolio volatility, and gain a potential sustainable income stream, particularly in retirement.