Defer a taxable event, achieve a higher level of diversification, and pass down highly appreciated real estate in a tax-efficient manner.
A 721 exchange, also known as an “UPREIT Transaction,” allows an investor to contribute property directly to the operating partnership of a real estate investment trust (“REIT”).
In exchange for contributing property, investors gain operating partnership units (“OP Units”). The exchange of property for OP Units is meant to qualify as a tax deferred exchange under IRC Section 1031.
Two-step transactions make acquiring REIT OP Units more achievable for a wider range of investors.
Often, high-net-worth investors don’t hold real estate that a REIT would want to acquire through an UPREIT Transaction. But in a two-step transaction, an investor sells their investment property to a third party and invests the proceeds in a DST on a tax-deferred basis under IRC Section 1031.
A REIT then acquires the property held by a DST or the DST interests in exchange for REIT OP Units under IRC Section 721. Therefore, exchanging into a DST can provide access to more diversified real estate portfolios held by REITs via their UPREIT structures.
Individuals who capitalize on 721 exchanges completed in conjunction with a larger diversified REIT may achieve greater diversification while also removing the concentration risk associated with owning a single asset in a single market. Though both 1031 exchange and 721 exchanges are tax-deferred transactions, REITs generally offer more diversification than are typically achieved via a 1031 exchange.
In addition, the OP Units of a REIT acquired via a 721 exchange typically provide the ability to convert OP Units into REIT shares and achieve partial or full liquidity. Partial liquidity may benefit individuals who prefer to spread their tax liability over time or simply want to access their capital.
Section 721 of the Internal Revenue Code allows owners of property (including real estate) to contribute, on a tax-deferred basis, their physical property to a partnership in exchange for interests in the partnership. REITs often hold their portfolio of real estate through an operating partnership (known as an Umbrella Partnership Real Estate Investment Trust, or “UPREIT” structure) to allow holders of real estate to effectively exchange their property for economic interests in the REIT (in the form of OP Units of the operating partnership) by contributing that property to the operating partnership in a 721 exchange. The OP Units typically have economic rights that are identical to the rights of the shares of the REIT and after a relatively short holding period can be converted into shares of the REIT (in a taxable transaction) for additional liquidity.
A 721 exchange is completed when an individual contributes an investment property to the operating partnership of a REIT. Instead of receiving cash for the sale of the property, the investor receives OP Units of the operating partnership in the UPREIT structure.
Portfolio Diversification – Compared to an individual owning a single property in a single market, 721 exchanges, when completed in conjunction with a larger diversified REIT, allow individuals to achieve greater diversification while removing concentration risk. While both the Section 1031 exchange and the 721 exchange are tax-deferred transactions, REIT portfolios are generally more diversified than single asset Section 1031 investments or DSTs.
Partial Liquidity – An individual property or a DST does not typically offer partial liquidity. The OP Units of a REIT, acquired via a 721 exchange, typically provide the ability to convert OP Units into REIT shares to achieve partial or full liquidity after a holding period. Partial liquidity may benefit real estate owners who prefer to spread their tax liability over time or simply want to access their capital.
Distributions and Potential Tax Benefits – Investors also receive any distributions generated by the DST prior to a 721 exchange and also typically receive distributions generated by the OP Units after such transaction. In addition, depending on the investor’s cost basis and other relevant factors, ownership of DST Interests and OP Units may have additional tax benefits primarily due to depreciation and other items.
There is no guarantee of success. Investors could incur a loss of all or a portion of their investment.
Important Disclosures
The information contained herein is not an offer to sell or a solicitation of an offer to buy any securities and is for training and educational purposes only. Such an offer or solicitation can be made only through a confidential private placement memorandum relating to an offering.
Cantor Fitzgerald and its affiliates do not provide tax, legal, or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal, or accounting advice. You should consult your own tax, legal, and accounting professionals before engaging in any transaction.
721 Exchange and Two Step Transaction Risk Factors to Consider
There is no guarantee of success. Investors could incur a loss of all or a portion of their investment.
No public market exists for DST Interests, and one is highly unlikely that any such market will develop.
There are substantial restrictions on the transfer of DST Interests.
There is no specified time that any property held by a DST will be liquidated, and the DST may not be able to sell any or all of the properties at a price equal to or greater than the purchase price paid for the DST Interests.
Delaware statutory trusts are a relatively new vehicle for real estate investment and are inflexible vehicles to own real property.
If a property is transferred (or the DST is converted) to a Springing LLC, investors will likely lose their ability to participate in a future Code Section 1031 Exchange with respect to the transferred property or properties.
Investors typically have no voting rights and will have no control over management of the DST or the properties.
There is no guarantee that investors will receive any return.
There is no guarantee of success. Investors could incur a loss of all or a portion of their investment.
There typically are substantial restrictions on the transfer of DST Interests.
There is no guarantee that an investor will be able to exchange their DST Interests for OP Units in an UPREIT.
As a partner in a partnership, a holder of OP Units may be allocated taxable income in excess of cash distributions it receives. Such holder may need to find alternative sources of cash to pay the tax liability on its allocated income.
In the event that an operating partnership sells the property contributed pursuant to a 721 Transaction, any “built-in gain” recognized upon such sale will be entirely allocated to the contributing investor. Such investor may have only limited rights to prevent or delay such a sale in accordance with a “tax protection agreement”.
The qualification requirements for a REIT are complex. There is no guarantee that, after a 721 Transaction, the REIT will continue to qualify as a REIT, which could adversely affect its operations and its ability to make distributions.