A Tax-Efficient Exit Strategy for Real Estate Investment Property Owners

As you know, many who own investment property are always on the lookout for tax-efficient investment strategies that not only help preserve wealth but also have the potential to offer attractive returns. Among the options available, the 721 exchange structure has been gaining significant traction among private real estate investors. 

This little-known investment strategy, which is part of the internal revenue code, may provide investment property owners with several benefits. A 721 exchange allows property owners to contribute real property in exchange for interests in an operating partnership of a real estate investment trust (REIT) that is structured as an umbrella partnership real estate investment trust, or UPREIT. The benefits of exchanging properties into a UPREIT range from tax deferral of capital gains to converting to passive income streams. In this article, we explore the 721 exchange/UPREIT transaction, its appeal, the intricacies of the exchange process, and its potential benefits and limitations.

The Appeal of the 721 Exchange 

Here are some key aspects that make the 721/UPREIT exchange strategy appealing:

Tax-Deferral Structure: One of the primary draws of the 721 exchange is the ability to defer capital gains tax. By participating in a 721 exchange, a taxpayer can postpone the tax liability that would typically arise from selling the property outright. By maintaining the sale proceeds that would otherwise be paid out in taxes, more funds are available for reinvestment.

Passive Income: Owning real estate often comes with the responsibilities of property management, which can be both time-consuming and challenging. The 721 exchange allows a property owner to enjoy the benefits of real estate ownership without the hassles of day-to-day management. They become a passive investor in the portfolio.

Portfolio Diversification: Spreading risk across multiple institutional-quality properties is a cornerstone of a sound investment strategy. Through the 721 exchange, property owners may gain exposure to a diversified range of properties managed by experienced professionals, reducing the risk associated with individual property ownership.

Professionally Managed Assets: The expertise of institutional real estate managers can make a significant difference in the performance of your clients’ investments. Through a 721 exchange, they can potentially tap into the skills and knowledge of seasoned real estate professionals who handle property selection, management, and optimization.

Liquidity: Liquidity is a crucial factor in any investment strategy. UPREIT structures may provide investors with a redemption option, providing them access to liquidity.  

At a snapshot level, the potential benefits of a 721 exchange are:

• Tax deferral on capital gains

• Professionally managed assets

• Portfolio diversification across institutional-quality properties

• Expertise of seasoned real estate managers

• Potential Liquidity in UPREIT structure

Understanding the 721 Exchange Process: A Case Study

Let's walk through the step-by-step process of a 721 exchange. Suppose an investment property owner (we’ll call him Steve) is looking to sell his properties. He has several motivations and goals driving this decision.

1. Steve has owned his rental properties for years, and he is tired of the hands-on management and upkeep they require. 

2. He wants to continue to own investment property but is looking for a passive ownership opportunity

3. Steve’s properties have appreciated in value significantly, and he wants to avoid paying capital gains tax

4. He would like to own a broad portfolio of high-quality commercial real estate diversified by property type and geography 

5. Ultimately, Steve would like to increase his liquidity options while also maintaining his step-up basis for estate-planning purposes. 

6. Steve perceives an investment in an UPREIT through a tax-deferred 721 exchange as a potential solution. However, often a property investor’s wish to contribute does not fit the strategic investment thesis of the partnership/UPREIT.

Steve may still achieve his goal of transforming his investment property into ownership in an UPREIT structure on a tax-deferred basis through a combination 1031/721 exchange. Combining a 1031 exchange with 721 is an elegant solution allowing investors to transform investment property into operating partnership units.

Property Sale and 1031 DST Exchange

Steve sells his investment properties and, employing a Qualified Intermediary (QI), uses the proceeds from the sales to invest in Delaware Statutory Trust (DST) via a 1031 exchange transaction, giving him access to a large portfolio of quality properties.

Property Contribution: Approximately three years later, the DST decides to contribute its properties to an UPREIT using a 721 exchange. As a result of that transaction, Steve’s fractional share interests in the DST is exchanged for Operating Partnership Units (OP units) in the REIT’s operating partnership.

Liquidity: Although Steve has certain limited liquidity options through the redemption of his OP units, he ultimately decides (for estate-planning purposes) to bequest equal amounts of this OP Units to his son and daughter. This allows them to receive the step-up basis and enabling them to make their own decision of whether they want to remain invested while still deferring the original capital gains tax or redeem their OP Units, which is a taxable event.

The hypothetical described above is only an example. It is important to be aware of potential limitations of a 721 exchange transaction as well. While the 721 exchange offers tax deferral, there is no additional tax deferral beyond the UPREIT level. In other words, OP Units cannot be exchanged back into real property for investors interested in active management. Capital gains tax will be due when OP units are redeemed for cash or converted to REIT shares. And if such OP Units are converted to REIT shares, there is no guarantee that the shares will be redeemed for cash, as they will be subject to the limits of the REIT redemption program.

The 721/UPREIT exchange transaction has emerged as a compelling tax-efficient strategy for real estate investment property owners. As the trend toward this approach continues to gain momentum, it's important for you to familiarize yourself with this strategy.

Some of the risks related to investing in commercial real estate include, but are not limited to: market risks such as local property supply and demand conditions; tenants’ inability to pay rent; tenant turnover; inflation and other increases in operating costs; adverse changes in laws and regulations; relative illiquidity of real estate investments; changing market demographics; acts of God such as earthquakes, floods or other uninsured losses; interest rate fluctuations; and availability of financing.

This communication is not intended as tax advice.