721 Exchange UpREIT
A 721 exchange, also known as an UPREIT (Umbrella Partnership Real Estate Investment Trust) transaction, is a tax-deferred strategy that allows real estate owners to contribute their property to a REIT in exchange for ownership in the REIT’s Operating Partnership (OP) units. This method is commonly used by investors who want to transition from direct property ownership into a diversified and professionally managed real estate portfolio while deferring capital gains taxes.
How a 721 Exchange Works
A 721 exchange is different from a 1031 exchange in that it does not involve a direct like-kind property swap. Instead, here’s how it typically works:
- Contribution of Property – The property owner transfers their real estate asset to a REIT’s operating partnership (OP) in exchange for OP units.
- Tax Deferral – The transaction does not trigger immediate capital gains taxes, as it qualifies under Section 721 of the IRS tax code.
- Conversion to REIT Shares – Over time, OP unit holders have the option to convert their partnership units into REIT shares.
- Diversification and Liquidity – Once converted, the REIT shares allow the investors to participate in the REIT redemption plan (if available) or the public market in the case of a public REIT and reduce the concentration risk of owning a single property.
Distributions are not guaranteed. The actual amount and timing of distributions to the investors may be determined based on financial condition and other market factors.
Benefits of a 721 Exchange
For property owners considering an alternative to direct real estate ownership, a 721 exchange provides multiple advantages:
- Tax Deferral – No immediate capital gains taxes upon transfer of the property.
- Passive Income – Owners no longer have to manage properties and instead receive dividends from the REIT.
- Diversification – Access to a professionally managed, broad portfolio of properties across multiple asset classes.
- Increased Liquidity – Increased Liquidity – REIT shares can potentially be sold for cash.
- Estate Planning Benefits – The OP units receive a step-up in basis when passed on to heirs, potentially eliminating capital gains tax.
Comparison: 721 Exchange vs. 1031 Exchange
Both 721 and 1031 exchanges allow real estate investors to defer capital gains taxes, but they differ in execution and long-term benefits.
| Feature | 721 Exchange | 1031 Exchange |
|---|---|---|
| Tax Deferral | Yes | Yes |
| Like-Kind Requirement | No | Yes |
| Property Control | No. Ownership converted to REIT shares | Yes |
| Liquidity | Potential future REIT share sales | Low |
| Diversification | Yes, across the REIT portfolio | No, limited to the replacement property |
| Estate Planning | OP units receive a step-up in basis | Property receives a step-up in basis |
Potential Drawbacks and Considerations
While the benefits of a 721 exchange are significant, there are also some considerations:
- Loss of Control – Once the property is contributed, the owner no longer makes decisions regarding its management.
- No Future 1031 Exchanges – Unlike a 1031 exchange, a 721 exchange is a one-way transaction. Once an owner converts OP units into REIT shares, they lose the ability to execute a 1031 exchange in the future.
- Market Volatility – REIT shares are subject to fluctuations in the stock market, which can impact the value of an investor’s holdings.
Ideal Candidates for a 721 Exchange
A 721 exchange is particularly well-suited for:
- Owners of Highly Appreciated Property – Who want to defer capital gains taxes.
- Investors Seeking Passive Income – Who prefer earning dividends rather than managing properties.
- Real Estate Owners Looking to Retire – Who want liquidity and estate planning advantages.
- Institutional or High-Net-Worth Investors – Who wish to diversify their portfolios into a professionally managed real estate investment vehicle.
Process of Executing a 721 Exchange
If you are considering a 721 exchange, here are the key steps:
- Evaluate Your Property – Ensure your asset aligns with the investment criteria of a REIT.
- Negotiate Terms – Work with the REIT to agree on the valuation and terms of the OP unit exchange.
- Transfer Ownership – The property deed is transferred to the REIT’s operating partnership.
- Receive OP Units – You receive OP units equivalent to the property’s value.
- Optional Conversion to REIT Shares – At a later time, you may choose to convert OP units into REIT shares.
- Sell REIT Shares (If Desired) – You can sell shares for liquidity, though capital gains tax may apply.
Frequently Asked Questions
Q: How long do I have to hold OP units before converting to REIT shares?
A: Most REITs require a minimum holding period, usually one to two years, before conversion to REIT shares.
Q: Can I perform a 1031 exchange after completing a 721 exchange?
A: No. Once the property has been transferred into an operating partnership, future 1031 exchanges are no longer allowed.
Q: Do all REITs offer 721 exchange opportunities?
A: No, only specific UPREIT structures accept property contributions through a 721 exchange.
Q: Will I still receive rental income?
A: No, you may receive dividends from the REIT, which may be comparable to rental income.
Q: What happens to my OP units when I pass away?
A: They receive a step-up in basis, meaning your heirs could avoid paying capital gains tax on past appreciation.
Securities of CalTier REIT I, Inc. are offered through North Capital Private Securities, a member of FINRA/SIPC. Private investments are highly speculative, illiquid, may involve a complete loss of capital, and are not suitable for all investors.
