Many real estate investors are familiar with a 1031 tax-deferred exchange, which allows an investor to defer paying taxes on the gain resulting from a sale of real estate. The investor must reinvest the proceeds in a qualifying like-kind property within a defined time period to defer the tax. Deferring taxes can be a high priority for an investor with a low tax basis in a property. The 1031 Exchange has a long history after originally being introduced into the tax code via the Revenue Act of 1921. The 721 Exchange, is a lesser-known alternative, but can also be a useful tool for a real estate investor to manage their tax burden and real estate investments.
Instead of selling a property for cash or exchanging for another property, in a 721 Exchange, an investor can contribute ownership of a property (or “sell”) to a partnership in exchange for a partnership interest or shares in the partnership. Similar to a 1031 Exchange, this transaction allows an investor to defer capital gains or depreciation recapture. Upon selling the property and receiving an ownership interest in the purchasing company, the seller becomes a passive owner.
There are several rules that a seller must consider when doing a 721 Exchange that include, how and when distributions are made, how long the seller must hold their ownership interest in the purchasing company, and how long the buyer should hold the property as an investment. Violating any of those rules could result in re-accelerating the capital gains tax the seller was attempting to defer. Any seller considering a 721 Exchange should consult a tax professional for more detailed advice.
In order for a 721 Exchange to work, the transaction must fit the investment parameters of each party. For the seller, they must determine if the purchasing company is a suitable investment to take the place of the property they plan to sell. For the buyer, they must decide if the property they are purchasing fits well into their existing portfolio and their strategic plan.
As a private real estate investment partnership, Investors Associated, LLP (“IA”) can offer sellers the opportunity to exchange property for IA partnership units and defer capital gains tax via a 721 Exchange. In fact, we completed a 721 Exchange for an industrial property in Northern Colorado in July of 2023.
At IA, we believe in a diversified approach to real estate investment and we have been able to utilize various tax strategies to grow our portfolio to the benefit of our investors. To learn more about the property selection process here at Investors Associated, LLP, please reach out to Jamie Stefan, Sr. VP of Investor Relations at (414) 797-3947 or [emailprotected].
FAQs
How does a 721 exchange work? In a 721 exchange, or "UPREIT", an investor contributes property to a REIT in exchange for units in an operating partnership that will then be converted into shares of the REIT itself.
What is Section 721 of the Exchange Code? ›
Section 721(a) generally provides that no gain or loss shall be recognized to a partnership or to any of its partners in the case of a contribution of property to the partnership in exchange for an interest in the partnership.
What is a 1031 exchange and how does it work? ›
A 1031 exchange is very straightforward. If a business owner has property they currently own, they can sell that property, and if they reinvest the proceeds into a replacement property, there's no immediate tax consequence to that particular transaction. They can defer any capital gains taxes associated with that sale.
How does section 721 work? ›
IRC Section 721 states that if a property is contributed to a partnership in exchange for an interest in the partnership, no gain or loss will be recognized from the exchange. A 721 exchange does not trigger a taxable event, and the IRS will not collect taxes on any realized capital gains from the property sale.
What is the difference between 721 and 1031 exchange? ›
Diversification: A 1031 exchange can help diversify your portfolio if you own other real estate types. A 721 exchange, however, offers even more opportunities for diversification by giving you instant access to an extensive portfolio of different property types and locations.
What are the disadvantages of the 721 exchange? ›
The 721 Exchange offers advantages such as passive income, investment diversity and estate planning benefits. However, there are also disadvantages, including restrictions on direct property contribution, potential tax implications upon subsequent conversion of OP Units and limitations on subsequent exchanges.
What are the disadvantages of a 1031 exchange? ›
Risks of 1031 Exchanges
- More complex tax documentation. In order to conduct a 1031 exchange, you'll need to file IRS Form 8824 with your tax return. ...
- Adherence to standards and regulations. ...
- Responsibility to choose an experienced qualified intermediary. ...
- Strict timelines may apply. ...
- Some taxes may still apply.
A vacation home, second home, or any other property used exclusively by the taxpayer for their own enjoyment, and which has no business or investment motive is not eligible for a 1031 exchange.
Do you have to reinvest all money in a 1031 exchange? ›
Reinvest all of your 1031 exchange proceeds, or net equity, from the relinquished property into the replacement property. Ensure the mortgage, or debt, on the replacement property is equal to or greater than that of the relinquished property to avoid debt relief.
How to report a section 721 exchange? ›
What are the Section 721 exchange reporting requirements? The 721 exchange itself is generally tax-deferred and does not require immediate reporting to the IRS. However, you will need to track the basis of your original property. This basis carries over to the partnership units you receive.
No gain or loss shall be recognized to a partnership or to any of its partners in the case of a contribution of property to the partnership in exchange for an interest in the partnership.
What is IRS Form 721? ›
More In Forms and Instructions
Publication 721 explains how the federal income tax rules apply to civil service retirement benefits received by retired federal employees (including those disabled) or their survivors.
What is the 721 structure? ›
A 721 exchange allows real estate property owners to contribute property, on a tax-free basis, in exchange for interests in an operating partnership of a real estate investment trust (REIT).
How to build wealth with 1031 exchange? ›
A 1031 exchange frees up more capital which means you can acquire a replacement property at a significantly higher value. By trading up for higher-value properties, you'll be able to build your wealth and hit investment goals quickly.
How to defer capital gains tax without doing a 1031 exchange? ›
Utilizing a Deferred Sales Trust, investors can defer capital gains taxes over time. Deferred Sales Trusts provide an alternative to 1031 exchanges for deferring capital gains taxes on appreciated assets.
