Pros and Cons of Deferring Taxes With a 721 Exchange

Real estate investors have long held two truths to be self-evident: first, that investing in real estate, while not risk-free, is one of the most effective ways to build wealth over the long run; and second, that one of the primary handicaps to building wealth through real estate investment comes in the form of taxes — more specifically, capital gains taxes.

Every time an investor sells an appreciated asset like real estate, Uncle Sam invariably requests a cut of the profits. And for most real estate investors, that unkindest of all cuts usually adds up to a robust 20% of the gain.

It’s not hard to see how frequent payment of capital gains taxes can kneecap the growth of wealth. For example, selling a property for $2 million after having paid $1.5 million for it five years ago represents an excellent return on investment — but 20% of a $500,000 gain amounts to a $100,000 tax payment. That’s a six-figure sacrifice that, considering compounding returns, can eventually balloon into a seven-figure opportunity lost.

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Understandably, real estate investors have welcomed any opportunity to defer or even eliminate capital gains taxes while remaining invested in real estate. It’s one of the reasons why 1031 exchanges, or like-kind exchanges, have become so popular among investors who are in the know. They enable people to “exchange” an appreciated piece of investment real estate for a more valuable one while simultaneously deferring the payment of capital gains taxes indefinitely.

But a savvy and small subset of real estate investors are also acquainted with a less-invoked form of exchange, one which may be tantalizing to tax-averse investors depending on their long-term goals: the 721 exchange, or UPREIT.

How a 721 exchange, or UPREIT, works

Here’s how it works in a nutshell: An investor facing a capital gains tax bill from the impending sale of an appreciated piece of investment real estate instead chooses to contribute (on a tax-deferred basis) their physical property to a partnership in exchange for interests in the partnership. These 721 transactions are structured in partnership with real estate investment trusts (REITs), which often hold real estate through an operating partnership known as an umbrella partnership real estate investment trust (UPREIT).

Through the UPREIT structure, an investor can transfer their real property to the UPREIT in exchange for operating partnership units, or OP units. These OP units are held for a minimum specified period, usually 12-24 months. During this time, they enjoy the same benefits (including dividend-like payments known as distributions) as holding actual shares in the REIT.

Capital gains taxes are deferred until the OP units are then converted into permanent shares in the REIT, and the investor is left with a high-quality, diversified investment that pays quarterly or monthly dividends.

Now if that sounds similar to a 1031 exchange into a REIT, which is otherwise prohibited by the fact that a REIT isn’t a “like-kind” transaction, then you’re getting the idea!

The investor starts with an appreciated piece of investment real estate, performs a tax-free transaction and, at the end of it, holds shares in a REIT, a diversified collection of investment properties.

Pros of an UPREIT

721 exchanges are an excellent tax mitigation strategy for real estate investors. Let’s look at the pros of an UPREIT:

Tax deferral. A capital gains tax of 20% (plus any potential state taxes) is deferred for at least a year, possibly longer. So there is no need to expound on the virtues of holding on to your own money for an extended period of time, as opposed to signing it over to the federal or state government! (Of course, it should be noted that the same deferral is available with other strategies, such as a 1031 exchange.)

Diversification. In a single transaction, a real estate investor can move from a controlling, active interest in a single property to fractional passive ownership of a portfolio of investment-grade properties that can be diversified in terms of geography, industry, tenant and sometimes even asset class.

Liquidity. Upon completion of a 721 exchange, the total value of the relinquished property is exchanged for REIT shares, which are often publicly traded and can be sold easily and efficiently if funds are needed.

Estate planning. Somewhat related to the advantages of liquidity, REIT shares are more easily divisible than fractional shares in a property or collection of properties can be and are more easily conveyed and liquidated at the time of the owner’s death. As such, they can play a valuable role in estate planning for real estate investors. (Again, it should be noted that a properly structured 1031 exchange can also serve as an excellent estate planning tool, even if shares of a piece of investment real estate property are more difficult to liquidate at the time of the owner's death.)

Hands-off investing. REIT shareholders are passive. REIT managers oversee the management of the REIT and its assets, relieving shareholders of the day-to-day responsibilities of property management. Obviously, whether this is a pro or a con depends entirely on the investor's comfort level with having someone else making decisions on their behalf.

Passive income. Besides no longer having to take an active concern when a tenant’s water pipe is compromised, REIT shareholders are often compelled by the high quarterly or monthly dividends paid by most REITs. The average dividend yield for REITs is typically 4% or more, with many paying well in excess of that rate.

Hedging of regulatory risk. While 1031 exchanges have existed for more than a century, 1031 exchange rules have also been amended by various legislative bodies. Calls to eliminate this “tax break for the rich” are common and frequently under active consideration. By comparison, 721 exchanges have been around for 50 years, essentially in the same form as they currently enjoy, with few calls for repeal or reform.

Potential capital appreciation. The RE in REIT stands for Real Estate — and as with all real estate, capital appreciation is a primary goal of the shareholders. Generally speaking, a booming real estate market will be reflected in the share price of most REITs, depending, of course, on their portfolios, and dividends may well increase over time as well.

Cons of an UPREIT

Of course, as is the case with all investment strategies, 721 exchanges aren’t perfect for everyone. As always, it’s important to consider the cons alongside the pros. For example:

Potential capital loss. Astute investors saw this one coming when they started reading about potential capital appreciation. What goes up can and does come down, and REIT share prices are not immune, as any investor in a commercial office building or regional mall REIT over the past several years can tell you.

A five-year chart of any commercial or mall REIT will paint the same picture: robust growth and dividend payment through January 2020; a yearlong plunge as COVID reshaped the marketplace; a roughly 18-month recovery as society tentatively tiptoed toward normalcy; and a yearlong backslide beginning around March 2022 as the Fed’s rate hikes provided a further shock to the system. Anyone counting on these REITs for growth of their nest egg instead saw their investment decimated and the security of the dividends threatened.

While the choice of REIT is critical, recent history is the latest demonstration that even the best-managed REITs can face circumstances and markets that they have no control over. The resulting volatility, especially for publicly traded REITs, can be jarring to an investor not accustomed to seeing their real estate investment traded on a daily basis. In addition, even with the least volatile REITs, past performance is no guarantee of future results.

Potential capital gains. Even absent such a calamity, REIT investors face the possibility of having to realize capital gains that are beyond their control. If a REIT’s management determines that it’s time to sell one of its holdings, the sale affects all shareholders. This is because the REIT has the right to return capital to the investor instead of reinvesting it in a new property, and returns of capital are taxable events to shareholders.

Investors are thus forced to admit a capital gain or loss when they file taxes, and a capital gain could result in the need to pay a capital gains tax, the very thing investors use 721 exchanges to avoid. Quality of management is a critical consideration — perhaps the ONLY consideration — in the selection of a REIT, but even with the very best management teams at the helm, investors may find themselves with an unpleasant surprise come Tax Day.

The drag of legacy assets. Both of the preceding problems can often be directly attributed to legacy assets, a term used to describe the properties already owned by the REITs when new shareholders invest. Properties that were assets upon acquisition, and perhaps have a history of being assets for years, can become liabilities to the REIT depending on circumstances (the previous examples of office properties and malls are two excellent examples).

Even identifying properties that are providing a drag on returns does not necessarily help the REIT's management, who now face the dilemma of retaining the underperforming asset (thereby hurting performance, the first scenario above) or selling it from the portfolio (thereby possibly locking in a taxable capital gain, the second scenario).

Potentially higher taxes. Even if an investor is fortunate enough to dodge a capital gains tax bill stemming from a return of capital, they are almost certain to face increased tax liability from the receipt of dividends. REITs receive special tax treatment from the IRS, but REIT investors get no such consideration; in fact, at the individual level, REIT dividends are frequently taxed the same as long-term capital gains, which is a much higher rate than other investment options.

Loss of flexibility. The finality of the 721 exchange is a significant consideration for any potential decision. Many investors participating in 721 exchanges choose to do so after one or more 1031 exchanges. But it’s important to note that while a 1031 exchange can be followed by additional 1031 exchanges (or other tax-deferred strategies), a 721 exchange results in the eventual receipt of REIT shares. And REIT shares are ineligible for other tax-deferred strategies.

Entering into a 721 exchange represents the final tax-deferred real estate transaction for that particular investment, regardless of how many have preceded it. That loss of flexibility is a critical consideration, particularly to real estate investors with a long history of being able to achieve tax deferral, and even more to those investors who are employing such strategies as an estate planning tool.

For real estate investors enamored of direct ownership and active management of real estate properties, UPREITs may not be a suitable choice. For those investors who want to remain invested in real estate, but no longer want the day-to-day responsibilities of direct ownership, or who don’t want to remain engaged in the process of 1031 exchanges, a 721 exchange may well represent an attractive opportunity.

The best decision any real estate investor can make is to consult with a capable and trusted financial adviser, who can fully appreciate the short- and long-term considerations involved in each individual investor's decision-making process. Real estate investors know that there is no one-size-fits-all strategy suitable to everyone, and the guidance of an excellent advisor may well be the most valuable asset anyone can acquire.