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The 721 UPREIT: How to Leverage a 1031 Exchange into a REIT

Real estate investors exploring exit strategies to defer their capital gains taxes may consider combining a 1031 exchange with a 721 UPREIT (Umbrella Partnership Real Estate Investment Trust) transaction, also known as a 721 Exchange.

A common question from investors is whether they can directly exchange into a REIT through a 1031 exchange and defer their capital gain taxes.

The answer: No.

REIT shares are not classified as "real property" for 1031 purposes. However, there’s a
process that needs to be followed that combines both the 1031 exchange and 721 UPREIT.

How the 721 UPREIT Process Works

A 721 UPREIT allows investors to contribute their property to a REIT's operating partnership in exchange for partnership units (OP Units).

In a typical scenario, an investor sells his property and might use a 1031 exchange to invest in a Delaware Statutory Trust (DST), which holds fractional interests in real estate. Afterwards, the DST is later acquired by a REIT and the investor can exchange their DST interests for operating partnership units (OP Units) of the REIT in a tax-deferred 721 Transaction. Lastly, the OP units that the investor received can be converted into the REITs common stock.

Timeline of a 721 UPREIT:

  • Sale of Property
  • 1031 Exchange
  • DST Purchase
  • 721 UPREIT exchanges DST
  • Ownership for OP Units
  • Convert OP Units to REIT Common Shares

Pros of a 721 UPREIT

The 721 UPREIT, offers real estate investors a strategic avenue for tax mitigation.

Here are some key benefits of an UPREIT:

  • Tax Deferral: Capital gains taxes, typically around 20% plus any applicable state taxes, are deferred for at least a year, potentially longer. This allows investors to retain their capital for an extended period instead of paying it to the federal or state government.
  • Diversification: Investors can transition from an active, controlling interest in one property to a passive ownership in a diversified portfolio of investment-grade properties, more so than DSTs. This diversification can span across different geographies, industries, tenants, and sometimes even asset classes.
  • Liquidity: After completing a 721 UPREIT, investors receive REIT shares. REITs that are publicly traded providing a higher level of liquidity as investors can sell their share on the open market. Additionally, if the REIT is non-traded or private they often offer liquidity but are scheduled at given intervals. In either scenario, the level of liquidity allows easy access to funds if needed for emergencies or personal use.
  • Estate Planning: REIT shares offer advantages in estate planning due to their ease of division and transferability compared to fractional shares in physical properties. They can be more readily liquidated upon the owner's death, making them valuable for estate planning purposes. While a well-structured 1031 exchange can also serve as an effective estate planning tool, REIT shares offer a more straightforward solution for liquidity at the time of the owner's death.

Disadvantages of a 721 UPREIT

  • No More 1031 Exchange: Investors can no longer engage in a 1031 exchange with the exchanged property. This loss of flexibility can be significant for those accustomed to deferring taxes through real estate transactions or using such strategies for estate planning.
  • Potential Capital Loss: REIT share prices can fluctuate. Volatility of publicly traded REITs can be challenging for investors unaccustomed to daily price changes in their real estate investments.
  • Legacy Assets: Properties owned by the REIT at the time of investment can become liabilities, impacting returns and potentially resulting in taxable capital gains if sold.

While UPREITs can offer diversification, liquidity, and tax deferral benefits, they also come with risks related to market volatility, potential tax liabilities, and a loss of investment flexibility.

It's important for investors to weigh these factors carefully and consult with financial and tax professionals before deciding if a UPREIT is the right choice for their investment portfolio.

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