The other tax deferred exchange: The 721 Exchange
Presented by: Rick Willoughby
If you like 1031s, you are going to love 721s.
As the market for 1031 exchanges is growing, so are the options for individual real-estate investors who conduct them. IRS §721 ("721 Exchange") allows a Taxpayer to exchange rental or investment real estate ultimately for shares in a Real Estate Investment Trust (REIT). This is called a §721 exchange, also known as an upREIT or §1031/721 exchange. An Umbrella Partnership Real Estate Investment Trust or upREIT implements the use of both The Internal Revenue Code Section § 1031 and § 721.
An UPREIT generally works like this: The investor executes a 1031 exchange for a tenant-in-common interest sponsored by a REIT, then after a period of time the investor will implement a § 721 exchange in which he/she will contribute the TIC property to a partnership. In exchange the investor receives interests in that partnership whose property portfolio is managed by a REIT; these interests are called operating partnership units (OP units). OP units carry the economic benefits of the REIT's entire portfolio, including distributions of any operating income. Investors still defer taxes because an exchange for operating partnership units (OP units) would not trigger capital-gains taxes.
Later OP units can be converted into shares of the associated REIT. The investor may liquidate the REIT shares pursuant to the REIT's predetermined redemption program or if the REIT is publicly traded the shares would be sold like any stock. TAXABLE EVENT: The receipt of REIT common shares in exchange for OP Units brings an end to an investor's tax deferral. Most importantly however the investor gains complete control and flexibility over the recognition of the capital gains tax by determining the timing and the quantity of shares sold in the Real Estate Investment Trust (REIT).
These kinds of exchanges are not new. Large, mostly institutional investors have long conducted such exchanges. Now with small investors acquiring institutional grade real estate as tenants in common those TIC properties are attractive acquisition targets for Real Estate Investment Trusts making the 721 exchange an alternative.
"You are sharing in a pool of properties [in terms of the REIT's portfolio], not just one," giving the investor diversification, says Louis S. Weller, a principal at Deloitte & Touche LLP's national real-estate tax services group in San Francisco. Tenancy-in-Common (TIC) is a form of holding title to real property as a co-owner who shares in any net income, tax shelters, and potential growth. TIC interests are direct investments in real estate, and are subject to all of the risks of owning, operating and disposing of real estate.
While investors doing this get diversity in terms of investments, there also is risk. For one thing, there is a loss in the investor's ability to keep exchanging. You cannot exchange back the operating partnership units for ownership or fractional ownership in a single property. You can only convert the units into REIT shares and taxes will be incurred in that transaction, but the investor gets to decide when and how many shares are sold, an option otherwise not available.
IRC Section 1031 & 721 are complex tax concepts, therefore you should consult your legal or tax professional regarding the specifics of your situation. This material is for educational purposes, it does not constitute an offer for purchase or sale of real estate securities. Such offers are solely made through the sponsor's Private Placement Memorandum, which is only available to accredited investors. Rick Willoughby is a Registered Principal offering securities and advisory services through Independent Financial Group, LLC, a registered broker-dealer and investment advisor. Member FINRA and SIPC. Independent Financial Group, LLC and Symphony Financial Services, LLC are not affiliated.