What is a 721 exchange (UPREIT)?

A “721 exchange” refers to a transaction under Section 721 of the Internal Revenue Code (IRC) in the United States. This section provides for the non-recognition of gain or loss on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for partnership interests or between partnership interests. Essentially, it allows for the tax-free exchange of real estate or other investment assets when they are contributed to a partnership (including limited partnerships and limited liability companies treated as partnerships for tax purposes) in exchange for an interest in that partnership.

The key aspect of a 721 exchange is that it must involve the transfer of property to a partnership in exchange for an interest in the partnership. Unlike a 1031 exchange, which is used specifically for real estate and requires the properties exchanged to be of “like-kind,” a 721 exchange is more flexible in terms of the types of properties that can be exchanged but is restricted to exchanges involving partnership interests.

This provision encourages investment and reinvestment in various ventures by deferring the tax that would otherwise be due upon the sale of the property. The deferred tax is not forgiven but is instead rolled into the basis of the partnership interest received, which will affect the tax treatment when the partnership interest is eventually sold or otherwise disposed of.

A 721 exchange is particularly useful in the context of real estate investment trusts (REITs) and other investment partnerships, allowing investors to contribute properties to these entities in exchange for an equity interest, deferring taxation and facilitating larger, diversified investment structures.

Difference Between a 721 Exchange and a 1031 Exchange

The 721 exchange and the 1031 exchange are both tax deferral mechanisms under the United States Internal Revenue Code, but they serve different purposes and have distinct rules and applications. Below is an overview of the key differences between a 721 exchange and a 1031 exchange:

 1. Code Section and Basic Principle:

• 721 Exchange: Governed by Section 721 of the Internal Revenue Code, it allows the deferral of gain or loss when contributing property to a partnership in exchange for an interest in that partnership. The tax is deferred until the partnership interest is sold or the partnership disposes of the contributed property.
• 1031 Exchange: Governed by Section 1031 of the Internal Revenue Code, it allows the deferral of capital gains taxes when an investor exchanges a real estate property for another “like-kind” property. The deferral continues until the new property is sold without reinvestment in another like-kind property.

 2. Application and Use:

• 721 Exchange: Used primarily for contributions to partnerships, including limited partnerships (LPs) and limited liability companies (LLCs) treated as partnerships for tax purposes. It’s often utilized in contributions to Real Estate Investment Trusts (REITs) and other investment vehicles.
• 1031 Exchange: Used for the exchange of real estate properties held for productive use in a trade or business or for investment. It’s widely used among real estate investors looking to roll over the capital gains from one investment property to another.

 3. Eligible Properties:

• 721 Exchange: Can involve a broader range of properties as it pertains to contributions to a partnership. The properties contributed do not need to be like-kind, as long as they are exchanged for partnership interests.
• 1031 Exchange: Strictly involves real estate. The properties exchanged must be of “like-kind,” which is broadly interpreted to mean any real estate held for productive use in a trade or business or for investment, regardless of grade or quality.

 4. Flexibility and Limitations:

• 721 Exchange: Offers flexibility in the types of entities and investments that can be involved but is limited to exchanges involving partnership interests.
• 1031 Exchange: Offers flexibility in the exchange of different types of real estate properties but is limited by the requirement that properties must be like-kind and the use of specific time frames for identifying and closing on replacement properties.

 5. Timing and Procedural Requirements:

• 721 Exchange: Generally does not have the strict timing constraints found in 1031 exchanges. The contribution to a partnership and the receipt of partnership interests can be structured over time.
• 1031 Exchange: Has specific timing requirements, including a 45-day identification period for replacement property and a 180-day period to complete the exchange from the date of sale of the relinquished property.

How Does a 721 Exchange Work?

A 721 exchange, named after Section 721 of the Internal Revenue Code, operates under a mechanism that allows investors to defer recognition of capital gains or losses when they contribute property to a partnership (or an entity treated as a partnership for tax purposes, such as some limited liability companies) in exchange for an interest in that partnership. Here’s an outline of how a 721 exchange works in practice:

 1. Preparation and Contribution:

• Owner of Property: An investor or property owner holds a property that has appreciated in value and is considering investment opportunities to defer capital gains tax.
• Partnership or REIT: The investor identifies a partnership or a Real Estate Investment Trust (REIT) willing to accept the property in exchange for partnership shares or units.

 2. Due Diligence and Agreement:

• Both parties conduct due diligence to evaluate the property’s value and negotiate the terms of the exchange, including the valuation of the partnership interest to be received in return for the property.

 3. Execution of Exchange:

• The property owner transfers the title of the property to the partnership or REIT.
• In exchange, the partnership or REIT issues partnership interests (shares or units) equivalent to the agreed value of the contributed property to the investor.

 4. Tax Deferral:

• Instead of recognizing a capital gain or loss at the time of transfer, the investor defers any tax liability until the partnership interests received are sold or otherwise disposed of.
• The basis of the contributed property (its original cost plus any improvements minus depreciation) transfers to the partnership interest. This adjusted basis will be used to determine the gain or loss when the partnership interest is eventually sold.

 5. Future Implications:

• For the Investor: The investor now holds an interest in the partnership or REIT, which may generate income through distributions and has the potential for appreciation in value.
• For the Partnership/REIT: The partnership or REIT acquires a new asset (the contributed property) that it can manage, develop, or sell under its investment strategy. The partnership basis in the property is the same as the investor’s adjusted basis at the time of the exchange.

 6. Reporting and Compliance:

• Both the contributing investor and the receiving entity must comply with IRS reporting requirements, including the filing of specific forms that detail the exchange.

 Key Considerations:

• Partnership’s Election: Notably, Section 721 exchanges are generally non-recognition events by default. However, the partnership has the option (though rarely exercised) to elect to recognize the gain if it prefers.
• Limitations: While Section 721 exchanges provide a mechanism for deferral of capital gains tax, they are subject to specific requirements and limitations. For instance, the exchange must be purely for partnership interests, and not all contributions may qualify if not done in the spirit of the law’s provisions.

What Is an UPREIT?

An UPREIT, which stands for Umbrella Partnership Real Estate Investment Trust, is a strategic structure utilized by real estate investment trusts (REITs) to allow property owners to contribute their real estate assets to a REIT indirectly through an umbrella partnership (often called an Operating Partnership or OP) in exchange for units of the partnership. This arrangement offers a tax-advantaged method for property owners to convert their real estate holdings into an interest in a diversified real estate investment portfolio while deferring capital gains taxes that would otherwise arise from a direct sale of the properties.

 How UPREITs Work

1. Structure: At the core of an UPREIT is the Operating Partnership, which is the entity that directly owns the real estate assets or interests. The REIT itself is the general partner and typically holds a significant portion of the OP units (partnership interests). Individual property owners become limited partners when they contribute their properties to the OP in exchange for OP units.

2. Tax Advantages: The key benefit of an UPREIT transaction for property owners is the deferral of capital gains taxes. This is because the exchange of real estate for OP units in the umbrella partnership is treated under Section 721 of the Internal Revenue Code, allowing the property owner to defer recognition of capital gains.

3. Liquidity and Investment: Owners who contribute their property to an UPREIT gain liquidity through their OP units, which can often be converted into shares of the REIT itself after a certain period. This provides the property owners with not just an exit strategy but also an opportunity to participate in the income and growth potential of a larger, diversified real estate portfolio.

4. Management and Operations: The REIT, through the Operating Partnership, takes over the management and operations of the contributed properties. This relieves the contributing property owners of the burdens of property management, while still allowing them to benefit from the properties’ income and appreciation.

 Benefits and Considerations

• Diversification: Property owners gain access to a diversified real estate portfolio, reducing the risk associated with owning single or few properties.
• Deferred Taxation: The UPREIT structure provides a mechanism to defer capital gains taxes, which can significantly enhance the long-term return on investment.
• Liquidity: OP units can often be converted into publicly traded REIT shares, providing liquidity to the property owners which is not typically available through direct real estate investments.

However, there are considerations and potential downsides, including the loss of control over the contributed properties, the reliance on the REIT’s management, and the specifics of the conversion terms from OP units to REIT shares, which might affect the timing and value of liquidity options.

What Is a DownREIT?

A DownREIT is a structure similar to an UPREIT (Umbrella Partnership Real Estate Investment Trust), but with a key difference in its approach to property and partnership arrangements. While both UPREITs and DownREITs are mechanisms that allow property owners to contribute their real estate assets to a real estate investment trust (REIT) in exchange for securities, typically deferring capital gains taxes in the process, the DownREIT structure involves a different configuration.

 How DownREITs Work

1. Structure: In a DownREIT, the property owner contributes their real estate asset not directly to the REIT, but to a subsidiary partnership of the REIT, often referred to as a “DownREIT partnership.” This partnership is separate from the operating partnership that typically holds the REIT’s assets in an UPREIT structure.

2. Tax Advantages: Like UPREIT transactions, the DownREIT arrangement allows property owners to defer recognition of capital gains taxes by receiving partnership units in the DownREIT partnership in exchange for their property. This tax deferral is similar to that offered by the UPREIT structure under Section 721 of the Internal Revenue Code.

3. Conversion and Liquidity: Holders of DownREIT partnership units may have the option to convert their units into REIT shares, which are often publicly traded, providing a path to liquidity. However, the specifics of conversion rights, including timing and valuation, can vary and are typically outlined in the terms of the partnership agreement.

 Differences from UPREITs

• Partnership Structure: The most notable difference is the partnership structure into which the property is contributed. In a DownREIT, the property is contributed to a subsidiary partnership rather than the primary operating partnership.
• Flexibility and Complexity: DownREIT structures may offer more flexibility in deal structuring, particularly in terms of how different investors’ interests are managed and aligned. However, this can also lead to increased complexity.
• Investment Options: Some DownREITs may provide property contributors with different types of securities or investment options, which may offer varying levels of income, voting rights, and conversion features.

 Benefits and Considerations

• Tax Deferral: Both UPREITs and DownREITs offer property owners the ability to defer capital gains taxes on the exchange of their real estate for partnership units.
• Diversification and Liquidity: Contributing property to a DownREIT can provide the property owner with an interest in a diversified portfolio of real estate assets, along with potential pathways to liquidity through conversion of partnership units to REIT shares.
• Complexity and Control: DownREIT structures can be more complex than UPREITs, and contributors should carefully consider the terms of the partnership agreement, including their rights and the management of the contributed property.

What Are the Primary Benefits of a 721 Exchange?

The primary benefits of a Section 721 exchange, which involves the contribution of property to a partnership (including REITs through UPREIT structures) in exchange for partnership interests, center around tax deferral, investment diversification, and liquidity. Here’s a detailed look at these benefits:

 1. Tax Deferral

• Capital Gains: The most significant advantage of a 721 exchange is the deferral of capital gains taxes. When property is contributed to a partnership in exchange for partnership interests, the contributor does not recognize immediate capital gains or losses on the exchange, thus deferring any tax liability that would have resulted from a direct sale of the property.
• Continued Deferral: The tax deferral can continue indefinitely as long as the partnership interest is not sold. When the partnership interest is eventually sold, the capital gains tax will be due, but the deferral allows for potential tax planning advantages.

 2. Investment Diversification

• Access to a Larger Portfolio: By exchanging property for an interest in a partnership, the contributor gains access to a diversified investment portfolio. This is particularly advantageous when contributing to a REIT (via UPREIT structures), as REITs often hold a broad range of real estate assets across various sectors and geographic locations.
• Risk Management: Diversification helps manage and mitigate risk by spreading exposure across different assets, as opposed to the concentrated risk associated with owning a single property or a small number of properties.

 3. Increased Liquidity

• From Real Estate to Tradable Interests: Real estate is inherently illiquid, but partnership interests, especially in publicly traded REITs, can be more easily bought and sold, providing increased liquidity to the contributor.
• Opportunity for Cash Flow: Depending on the structure of the partnership and the terms of the exchange, holding partnership interests can provide a steady stream of income through distributions, which may be more liquid and flexible compared to managing rental income directly from real estate properties.

 4. Estate Planning and Succession Benefits

• Flexibility in Estate Planning: The transfer of partnership interests can be more straightforward than the transfer of real estate, offering advantages in estate planning and succession. This can facilitate the smooth transition of wealth to heirs with potentially favorable tax implications.
• Partnership Interests as Estate Assets: Holding partnership interests instead of direct real estate can simplify the management and disposition of estate assets, offering more flexibility in executing the estate’s strategy.

 5. Management Relief and Professional Oversight

• Relief from Direct Management: Contributors of property to a partnership, especially to a professionally managed REIT, are relieved of the day-to-day responsibilities of property management.
• Benefit from Professional Management: The property and the broader portfolio benefit from professional management, which can lead to better maintenance, higher occupancy rates, and overall improved asset performance.

What Are the Potential Disadvantages of a 721 Exchange?

While a Section 721 exchange offers several benefits, such as tax deferral and investment diversification, it also comes with potential disadvantages that investors should consider. These drawbacks can impact the decision-making process and the overall outcomes of the exchange. Here are some key potential disadvantages:

 1. Loss of Control

• Management and Decision-Making: By contributing property to a partnership or a Real Estate Investment Trust (REIT), the contributor loses direct control over the property. Decisions regarding property management, leasing, and disposition are made by the partnership or REIT management.
• Terms of Partnership: The specific terms of the partnership or REIT may not always align with the individual contributor’s interests or objectives, potentially leading to disagreements or dissatisfaction with the handling of the contributed property.

 2. Complexity and Costs

• Transaction Complexity: The process of executing a 721 exchange can be complex, involving negotiations, valuations, and legal structuring. This complexity may require significant time and effort to navigate.
• Professional Fees: Investors may incur substantial legal, tax advisory, and accounting fees to ensure the transaction complies with IRS regulations and to navigate the complexities of the partnership structure.

 3. Tax Implications

• Deferred, Not Eliminated: While a 721 exchange allows for the deferral of capital gains taxes, it does not eliminate them. Taxes will eventually be due upon the sale of the partnership interests, potentially at higher future tax rates.
• Basis Carryover: The investor’s basis in the contributed property carries over to the partnership interest. This lower basis can result in higher taxable gains when the partnership interest is sold.

 4. Liquidity Concerns

• Conversion Restrictions: If the partnership interests are in a non-publicly traded entity, converting those interests back into cash or other liquid assets may be subject to restrictions, delays, or unfavorable terms.
• Market Conditions: The ability to sell partnership interests, even in a publicly traded REIT, can be influenced by market conditions. Fluctuations in the REIT’s performance or broader market downturns can affect the liquidity and value of the interests.

 5. Regulatory Risks

• Changes in Tax Laws: Future changes in tax legislation could impact the advantages associated with a 721 exchange, potentially affecting deferral opportunities or imposing additional taxes or requirements on partnership interests.
• Compliance Risks: Failing to comply with the complex IRS regulations governing 721 exchanges and partnership interests can result in penalties and the loss of tax deferral benefits.

 6. Long-term Commitment

• Investment Horizon: A 721 exchange often represents a long-term investment commitment. Investors must be prepared for the possibility that their objectives or financial needs may change, while their ability to respond by divesting partnership interests quickly or without loss may be limited.

What Situations Would be Appropriate for Considering a 721 Exchange?

A Section 721 exchange, allowing property owners to contribute their property to a partnership (such as a Real Estate Investment Trust or REIT) in exchange for partnership interests without immediate tax recognition, is particularly advantageous in specific situations. Here are several scenarios where considering a 721 exchange would be appropriate:

 1. Seeking Tax Deferral on Capital Gains

• High Appreciation: Property owners who have real estate that has significantly appreciated in value and are looking to sell may face substantial capital gains taxes. A 721 exchange can defer these taxes, providing a more tax-efficient transition.

 2. Desiring Investment Diversification

• Concentration Risk: Owners with a large portion of their wealth tied up in a single property or a small number of properties may seek to reduce risk through diversification. Exchanging property for interests in a diversified REIT can spread risk across a broader portfolio of assets.

 3. Looking for Management Relief

• Management Burden: Individuals tired of the active management responsibilities and operational hassles of property ownership might consider a 721 exchange to gain a passive investment position while professional managers take over day-to-day operations.

 4. Estate Planning and Succession

• Estate Liquidity and Transition: Property owners planning for estate succession may find a 721 exchange attractive for simplifying estate matters. Partnership interests can be more easily divided and transferred than direct real estate, offering a strategy for estate liquidity and equitable distribution.

 5. Exploring Exit Strategies from Real Estate Investments

• Market Exit: Investors looking for an exit strategy from the real estate market, especially in a high market, may use a 721 exchange to transition into a liquid, diversified investment without triggering immediate capital gains taxes.

 6. Achieving Greater Liquidity

• Need for Liquidity: For those needing greater liquidity than direct real estate investment typically offers, converting real estate into partnership interests, especially in publicly traded REITs, can provide a more liquid asset that may be sold more readily.

 7. Participating in Larger Investment Opportunities

• Access to Larger Deals: Small to medium-sized property owners may find a 721 exchange appealing as a way to participate in larger, potentially more lucrative real estate investments and projects managed by experienced REITs.

 8. Real Estate Developers or Investors Rebalancing Portfolios

• Portfolio Optimization: Developers or investors looking to rebalance or optimize their portfolios may use a 721 exchange to exit certain positions in a tax-efficient manner, reallocating resources to more strategic investments.

 9. REITs Looking to Expand Portfolios

• Strategic Acquisitions: REITs seeking to expand their asset base may encourage property owners to engage in 721 exchanges, offering an attractive, tax-efficient method for integrating new properties into their portfolios.

What Is a Good 721 Exchange Candidate Property?

A good candidate property for a Section 721 exchange, where property is contributed to a partnership (such as a Real Estate Investment Trust or REIT) in exchange for partnership interests, typically meets several criteria that align with the strategic advantages of such an exchange. The suitability of a property for a 721 exchange is influenced by factors related to the property’s financial performance, the owner’s tax situation, and investment goals. Here are the key characteristics of a property that would make it a good candidate for a 721 exchange:

 1. Highly Appreciated Property

• Properties that have significantly appreciated in value since their purchase are prime candidates. The 721 exchange allows the property owner to defer capital gains taxes that would be due upon a direct sale.

 2. Property Generating Stable Income

• Properties with a strong, stable income stream are attractive to partnerships and REITs. Consistent rental income indicates a healthy, viable asset that can contribute positively to the partnership’s portfolio.

 3. Properties with Untapped Potential or Value-Add Opportunities

• Properties that have potential for further development, renovation, or repositioning but require additional capital or expertise to realize this potential are good candidates. Partnerships and REITs often have the resources to unlock this value.

 4. Diversification Needs for the Owner

• Property owners with a significant portion of their wealth concentrated in a single property or a specific real estate sector stand to benefit from a 721 exchange by gaining access to a diversified portfolio of real estate assets.

 5. Owners Seeking Management Relief

• Owners looking to reduce or eliminate the burden of active property management while still wanting to maintain exposure to real estate investments may find a 721 exchange appealing.

 6. Estate Planning Considerations

• Properties that are part of an estate planning strategy, where the goal is to simplify estate management and provide for orderly succession, can be good candidates. The exchange can facilitate the transfer of value to heirs in a more liquid and manageable form.

 7. Properties in Strong Markets or Desirable Locations

• Properties located in areas with strong rental markets, high demand, and appreciation potential are typically desirable to partnerships and REITs. Such locations often indicate a lower risk and higher potential for stable or increasing value.

 8. Large Single-Asset Owners

• Owners of large, valuable properties who are looking to retire, rebalance their investment portfolio, or otherwise transition away from active management can benefit from the liquidity and diversification offered through a 721 exchange.

Can You Combine a 1031 Exchange With a 721 Exchange?

Yes, you can combine a 1031 exchange with a 721 exchange in a strategic manner to leverage the benefits of both tax deferral mechanisms under the United States Internal Revenue Code. This combination allows investors first to defer capital gains taxes on the sale of a real estate property through a 1031 exchange and then subsequently contribute the replacement property to a partnership or a Real Estate Investment Trust (REIT) in exchange for partnership interests or shares, under the provisions of a 721 exchange. Here’s how this process typically unfolds:

 Step 1: 1031 Exchange

• Initial Sale: The investor sells a real estate property and intends to reinvest the proceeds in another property to defer capital gains taxes through a 1031 exchange.
• Replacement Property: Within the specified timelines of a 1031 exchange (45 days to identify the replacement property and 180 days to complete the acquisition), the investor acquires another “like-kind” property. This step defers the recognition of capital gains taxes on the sale of the original property.

 Step 2: 721 Exchange

• Partnership Contribution: After acquiring the replacement property through a 1031 exchange, the investor can then contribute this property to a partnership or REIT in a subsequent transaction under Section 721. This contribution is made in exchange for partnership interests or REIT shares.
• Further Tax Deferral: The 721 exchange allows the investor to defer any capital gains taxes that would be recognized from the contribution of the property to the partnership/REIT. The investor now holds a liquid, diversified investment in the form of partnership interests or REIT shares, instead of directly owning real estate.

 Strategic Considerations

• Timing and Planning: Combining these exchanges requires careful timing and planning. The initial 1031 exchange must be completed within the required timelines, and the subsequent 721 exchange will also need to be negotiated and structured to comply with tax laws.
• Tax Implications: The investor effectively defers capital gains taxes from the sale of the original property and also from the contribution of the replacement property into the partnership/REIT. However, it’s crucial to consult with tax professionals to navigate the complexities and ensure compliance with IRS regulations.
• Investment Goals: This strategy should align with the investor’s long-term investment goals, offering a way to transition from active property management to a more passive investment in a diversified real estate portfolio.

Can You Execute a 1031 Exchange After a 721 Exchange?

Performing a 1031 exchange after a 721 exchange introduces a complex scenario with specific considerations. Here’s an outline of the conceptual framework and key considerations for attempting such a sequence:

 Understanding the Exchanges

• 721 Exchange: In a 721 exchange, an investor contributes property to a partnership (such as a Real Estate Investment Trust, or REIT) in exchange for partnership interests. This transaction can defer recognition of capital gains taxes on the contributed property.
• 1031 Exchange: In a 1031 exchange, an investor sells investment property and reinvests the proceeds into another “like-kind” property, deferring capital gains taxes on the sale.

 Conceptual Sequence

After completing a 721 exchange, the investor holds partnership interests in the entity (e.g., a REIT) rather than direct ownership of the real estate. The key challenge in then performing a 1031 exchange is that 1031 exchanges are designed for real estate assets, not partnership interests. Here are the critical considerations:

 Challenges and Considerations

• Nature of Ownership: After a 721 exchange, the investor’s real estate is transformed into partnership interests or shares in a REIT, which are not considered “like-kind” property to real estate under Section 1031. The IRS generally does not allow 1031 exchanges of partnership interests for real estate or vice versa.
• Indirect Ownership: Since the investor now indirectly owns real estate through partnership interests, executing a 1031 exchange would require the partnership or REIT itself to sell real estate and engage in the 1031 exchange. The individual investor cannot directly initiate a 1031 exchange for properties owned by the partnership/REIT.
• Partnership/REIT Considerations: If the partnership or REIT decides to sell a property and reinvest in another property, it can potentially structure transactions to achieve tax deferral benefits similar to a 1031 exchange. However, these actions are at the entity level, not the individual investor level.
• Potential Workarounds: In theory, if an investor wants to transition from partnership interests back to direct real estate ownership and use a 1031 exchange, complex strategies might involve liquidating partnership interests, potentially recognizing gain, and then using the proceeds to purchase real estate directly. However, this would not be a straightforward sequence of a 721 followed by a 1031 exchange and would likely involve significant tax implications.

 Conclusion

Directly performing a 1031 exchange after a 721 exchange is not feasible in the way it might initially seem, due to the transformation of real estate into partnership interests. Any attempt to move from partnership interests back to direct real estate ownership, with the intention of leveraging a 1031 exchange, would require careful planning, likely involve intermediate steps with tax consequences, and necessitate consultation with tax and legal professionals to navigate the complex IRS regulations and ensure compliance.