For investors looking for a way to defer capital gains tax when selling real estate, there are a variety of strategies to exploit depending on the circumstances.
Usually a 1031 exchange comes to mind; however, an often underused tool that helps investors achieve a similar outcome is a 721 exchange, or umbrella partnership real estate investment trust (UPREIT). Both 1031 and 721 exchanges offer advantages and disadvantages, but ultimately the choice depends on the specific goals of the investor.
These two strategies allow investors to defer capital gains taxes on the sale of their property. In a 721 exchange, the investor contributes their property to the apex company, also called the operating company (OP), of an UPREIT. In return for contributing ownership, the investor receives equity interests in the general partnership and becomes a unitholder, which not only allows for tax deferral, but also the opportunity for further diversification.
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By running a 721 exchange, an investor can expand their real estate portfolio across a range of assets worth millions or even billions of dollars. This allows them to diversify their holdings instead of being limited to owning just one or two properties.
On the other hand, 1031 exchange rules allow investors to defer capital gains tax by exchanging one (or more) physical investment property for another of equal or greater value. This method is often used by investors looking to diversify their real estate portfolio without incurring an immediate tax liability. However, the investor must reinvest in an investment property of the same nature. A like-kind property refers to a property having the same character or nature or being part of the same class. The grade or quality of the property does not matter.
Most real estate properties will be similar to other properties. The initial property can be a multi-family housing complex and you can exchange it for an industrial warehouse property. Many customers take advantage Delaware Statutory Trusts (DST) as an investment vehicle because they offer a turnkey solution that qualifies for 1031 exchanges.
A DST is a legal entity with a flexible approach to the design and operation of the entity. Investors hold a pro rata interest in the trust and are entitled to receive interest and distributions based on their investment in the trust. This form of real estate ownership allows an investor to enjoy the benefits of a real estate allocation without the headaches of direct real estate ownership, such as property maintenance and tenants. DSTs can hold one or more properties to provide additional exposure to investors and a ready-made solution for a 1031 exchange.
On the other hand, investors give up a level of control over the management of the property and have limited cash, which makes it difficult to cash in the DST.
However, some investors may consider using an UPREIT 721 rather than a DST, as it offers more control over liquidity. For example, this investment tool could benefit an investor looking to fund their child’s further education or looking to fund a major life event, as it allows exposure to real estate without the illiquidity of a DST.
This offers the investor the possibility of converting shares of operating partnership into REITs shares and liquidate them as needed, allowing greater flexibility in managing tax liability and liquidity compared to DSTs, which require waiting for the entire asset to be sold.
Although it should be kept in mind that non-traded REITs have variable redemption plans, so liquidity is not a guarantee. Besides, liquidity (opens in a new tab) may be further restricted, as an investor’s ability to sell stocks is often determined by the fund manager.
Older investors who have traded DST 1031s throughout their lives might be attracted to the idea of switching to 721 UPREIT trades. Perhaps they are tired of completing the exchange process every five to ten years and are ready to prepare for a completely self-contained experience.
However, once you complete a 721 trade, you cannot continue trading. Any movement of money from UPREIT will be a taxable event in the future. This means that if you decided to convert your OP shares into REIT shares for potential liquidity, it would be a taxable event. From then on, there is no longer any possibility of participating in the increase in value of the assets until you pass them on to your heirs. Investors looking to continue trading to participate in realized appreciation may prefer a DST.
We also see investors choosing DSTs over UPREITs if they are not interested in other diversification. If you have invested in multi-family apartment complexes throughout your career, you may believe in a particular DST asset after performing the proper due diligence. You may not agree with the REIT’s acquisition strategy and wish to control the particular asset(s) in which you are investing.
REITs are generally open-ended investment pools where assets are deployed at the managers’ discretion, and investment objectives and strategies may change over time.
Finally, the 721 UPREIT and DST 1031 exchanges offer investors the opportunity to eliminate tax liability when passing investments on to their heirs. When the investment is transferred to the heirs of the investor, the heirs receive an increase in the cost base equal to the fair market value at the death of the investor. The heirs do not inherit the recovery of depreciation or tax debts on real estate capital gains. The type of investment you leave to your heirs may be a factor in your decision making.
Ultimately, the choice between a 721 UPREIT and a 1031 exchange depends on the specific goals and circumstances of the investor. For those looking for diversification and more control over liquidity, a 721 UPREIT may be preferable. On the other hand, while a 1031 exchange offers more limited options for diversification, it allows investors to continue to reallocate their real estate portfolio without incurring immediate tax liability.
If you want to learn more about the similarities and differences between real estate investment vehicles, our blog at 1031 Crowdfunding (opens in a new tab) provides a comprehensive overview of your options.