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Thinking about investing in commercial real estate properties but unsure where to start?

Commercial real estate investors have access to a wide range of investment opportunities, from real estate investment trusts (REITs) to private investments. These options allow investors to generate passive income while benefiting from potential higher returns and long-term investment strategies.

However, commercial real estate transactions require careful planning. Unlike residential properties, the commercial real estate industry involves complex financing, risk assessment, and strategic property selection.

In this blog, we’ll break down expert tips to help you navigate the commercial real estate industry and make informed choices when buying commercial properties.

Expert Tips for Buying Commercial Properties

Research Market Trends

If you want to succeed in commercial real estate investing, understanding market trends is essential. Understanding market conditions can help investors make informed decisions, though market trends are subject to economic shifts and unforeseen events. Here’s how to research market trends effectively:

Study Local Economic Conditions

Commercial property values and rental rates are closely tied to the local economy. Pay attention to:

• Job Growth: Areas with growing employment often attract real estate investors looking to acquire properties in thriving business districts.
• Population Growth: A rising population increases demand for office buildings, shopping centers, and industrial real estate.
• Business Openings and Closures: Tracking local businesses helps gauge the health of a commercial real estate market.

Analyze Vacancy and Rental Rates

Vacancy rates and rental prices reveal a lot about a market’s health. Low vacancy rates suggest strong demand, while high vacancy rates can indicate an oversupply of properties.

• Look at historical data to spot patterns — Is the market becoming more competitive, or is demand slowing down?
• Compare rental rates to similar markets to understand whether you’re getting a fair deal.
• Evaluate future construction projects — An influx of new properties could increase competition and push down rental rates.

Identify Market Cycles

Real estate markets go through cycles of expansion, peak, contraction, and recovery. Knowing which phase the market is in helps you time your investment correctly:

• Expansion: Rising demand and rental rates, with low vacancy rates — a good time to buy.
• Peak: High property values and increasing competition — proceed cautiously.
• Contraction: Rising vacancy rates and falling rents — opportunities to buy undervalued properties.
• Recovery: Improving demand and stabilizing rents — a time to hold and monitor.

Research Future Development Plans

City planning and future development projects can have a huge impact on commercial property values.

• Check with local planning offices to find out about new infrastructure, zoning changes, and development incentives.
• Proximity to new transportation hubs, shopping centers, or entertainment districts can increase property values. 
• On the flip side, if new developments create oversupply, it could drive down rental rates and occupancy.

Location Matters

In real estate, location isn’t just important — it’s everything. A property's location determines its cash flow and profitability, influencing overall investment returns. Choosing the right location can make the difference between a profitable investment and a struggling one. Here’s how to evaluate a location effectively:

Understand the Neighborhood

Start by researching the neighborhood where the property is located. A property in a thriving area will likely attract more tenants and hold its value better over time. Consider:

• Demographics: Who lives and works in the area? Are there young professionals, families, or retirees?
• Income Levels: Higher income levels often mean more spending power, which supports businesses and boosts property value.
• Crime Rates: Crime rates can influence tenant and business interests, but factors such as economic shifts, law enforcement policies, and local regulations also play a role.
• School Districts: Good schools attract families and increase property demand.

Accessibility and Transportation

How easy is it to reach the property? Accessibility can significantly impact tenant interest and customer foot traffic.

• Public Transport: Properties near subway stations, bus stops, or train stations attract more tenants.
• Major Roads and Highways: Easy access to major roads makes it convenient for customers, suppliers, and employees.
• Parking Availability: Lack of parking can deter tenants and customers, while ample parking increases property appeal.
• Walkability: High walkability scores increase customer traffic, especially for retail and office spaces.

Nearby Amenities and Services

Proximity to key amenities adds value to a commercial property. Tenants and customers want convenience. Look for:

• Restaurants and Cafés: Office tenants value nearby lunch and coffee options.
• Shopping Centers: Retail tenants benefit from being near established shopping destinations.
• Gyms and Fitness Centers: These increase foot traffic and make the area more attractive to health-conscious tenants.
• Hospitals and Emergency Services: Proximity to healthcare facilities can increase tenant confidence, especially for office and medical tenants.

Economic and Business Growth

Choose locations in areas with strong economic growth and business development. Growing economies support higher rents and property values.

• New Business Openings: An influx of new businesses signals a strong local economy.
• Corporate Headquarters: Locations near major company offices tend to have more stable demand for office and retail spaces.
• Government Investments: Infrastructure projects, tax incentives, and redevelopment plans boost long-term property values.
• Tourism and Entertainment: High foot traffic from events, sports stadiums, or cultural attractions increases property demand.

Zoning and Future Development Plans

Before buying, check local zoning laws and future development plans. Zoning determines how you can use the property and what types of tenants you can attract.

• Commercial Zoning: Ensure the property is zoned for the type of business you want to lease to.
• Mixed-Use Zoning: Properties in mixed-use areas often attract more foot traffic and higher tenant interest.
• Future Development: New construction nearby could increase or decrease property value. A new shopping center might increase demand — or create competition.
• Rezoning Potential: If local authorities plan to rezone the area, it could change the value of your property.

Evaluate Property Condition

The condition of a commercial property plays a major role in its value, maintenance costs, and long-term profitability. A property that looks good on the surface might have hidden issues that could lead to costly repairs down the road. Proper evaluation helps you avoid surprises and ensures that your investment remains profitable. Here’s how to assess the condition of a commercial property effectively:

Inspect the Building Structure

Start by examining the overall structure of the property. A strong structure may contribute to long-term durability, though regular maintenance and market conditions affect property value. Look for:

• Foundation: Check for cracks or uneven surfaces, which may signal settling or structural weakness.
• Roof: Inspect the roof for leaks, sagging, or missing shingles. Roof replacements are costly, so knowing the condition upfront is key.
• Walls and Floors: Look for cracks, water damage, or mold. These could indicate deeper issues with moisture or structural integrity.
• Windows and Doors: Test if they open and close properly. Poor insulation or misaligned windows can lead to energy loss and higher utility costs.

Evaluate the Electrical and Plumbing Systems

Faulty electrical or plumbing systems can lead to costly repairs and potential downtime for tenants. Make sure all systems are in working order:

• Electrical Panels: Check for outdated wiring, overloaded circuits, and proper grounding.
• Lighting: Test the interior and exterior lights to ensure they work and comply with safety codes.
• Water Pressure: Turn on faucets and flush toilets to check for consistent water flow and drainage issues.
• Leaks and Corrosion: Inspect pipes for rust, leaks, and mineral buildup, which can signal long-term plumbing problems.

Check the HVAC (Heating, Ventilation, and Air Conditioning) System

An outdated or faulty HVAC system can lead to high energy bills and tenant complaints. Assess:

• Age of the System: HVAC systems typically last 10–20 years. Older units are less energy-efficient and more prone to breakdowns.
• Maintenance Records: Ask for service history to see if the system has been regularly maintained.
• Air Quality: Ensure vents and filters are clean to avoid health and safety issues.
• Temperature Control: Test the system to confirm it heats and cools evenly throughout the property.

Environmental and Code Compliance

A property that doesn’t meet local building codes or environmental standards can lead to fines and legal trouble. Ensure compliance with:

• Zoning Laws: Make sure the property is zoned for its intended use.
• Environmental Risks: Check for hazardous materials like asbestos, mold, or lead paint.
• Accessibility: Ensure the property meets ADA (Americans with Disabilities Act) standards for ramps, elevators, and bathrooms.
• Energy Efficiency: Older buildings may need upgrades to meet modern energy efficiency requirements.

Understand Renovation and Maintenance Costs

A property in poor condition may still be a good investment if renovation costs are manageable. Create a realistic budget for:

• Immediate Repairs: Address critical issues like leaks, structural damage, or electrical problems.
• Cosmetic Upgrades: Consider painting, flooring, and new signage to improve aesthetics.
• Future Maintenance: Estimate ongoing costs for landscaping, HVAC servicing, and repairs.

Financing Strategy

A structured financing strategy may help investors manage risk and optimize cash flow in commercial real estate transactions. How you finance a property impacts your cash flow, profitability, and overall return on investment (ROI). Unlike residential properties, commercial real estate financing involves higher amounts, stricter requirements, and more complex terms. Here’s how to build a smart financing strategy:

Understand Your Loan Options

Commercial real estate loans come in different types, each with its own terms and benefits. Understanding these options helps you choose the one that best fits your financial situation and investment goals:

• Conventional Loans: Traditional loans offered by banks or credit unions. These often require a large down payment (20%–30%) and a strong credit score.
• SBA Loans: Backed by the Small Business Administration (SBA), these loans offer lower down payments (as low as 10%) and longer terms, making them ideal for small business owners.
• Bridge Loans: Short-term loans used to cover immediate financing needs until long-term funding is secured. They have higher interest rates but provide quick access to capital.
• Hard Money Loans: Private loans based on the property’s value rather than the borrower’s creditworthiness. They have short terms and higher interest rates, making them suitable for quick-turnaround projects.
• CMBS (Commercial Mortgage-Backed Securities): Loans pooled together and sold to investors. They offer fixed terms and competitive rates but have strict repayment structures.

Assess Your Creditworthiness

Lenders will evaluate your financial background before approving a loan. A positive credit history may improve loan eligibility, though lender requirements vary based on market conditions and individual financial circumstances.

• Credit Score: Most lenders require a credit score of 650 or higher for commercial loans.
• Debt-to-Income Ratio (DTI): Lenders prefer a DTI below 45%, meaning your total monthly debt payments should be less than 45% of your monthly income.
• Cash Reserves: Having enough cash reserves to cover at least six months of loan payments improves your loan approval chances.
• Business History: If the loan is for a business property, lenders may evaluate the business’s financial performance and stability.

Calculate Your Down Payment and Loan Terms

Commercial real estate loans typically require larger down payments than residential loans. Planning your down payment and understanding loan terms helps you manage cash flow:

• Down Payment: Most commercial loans require a down payment of 20%–30%. SBA loans may require as little as 10%.
• Interest Rates: Commercial loan rates fluctuate based on market conditions, lender criteria, and individual financial standing.
• Loan Term: Commercial loans typically have terms of 5-20 years, but financing conditions may vary based on market interest rates and lender policies. Longer terms mean lower monthly payments but higher overall interest costs.
• Amortization: Many commercial loans are partially amortized, meaning a large balloon payment is due at the end of the loan term.
  

Plan for Additional Costs

Financing a commercial property involves more than just loan payments. Budgeting for additional costs helps you avoid cash flow problems:

• Closing Costs: Expect to pay 2%–5% of the property’s value for loan origination fees, legal fees, and title insurance.
• Maintenance and Repairs: Older properties may require immediate repairs or upgrades.
• Property Taxes and Insurance: These ongoing costs can fluctuate based on local tax rates and market conditions.
• Tenant Improvements: If the property will be leased, you may need to make modifications to meet tenant requirements.

Work with Experts

Investing in commercial real estate is complex. It involves navigating market trends, financing terms, legal requirements, and property management challenges. That’s why working with experienced professionals can make a big difference. Experts help you avoid costly mistakes, negotiate better deals, and uncover opportunities you might miss on your own. Here’s why partnering with the right professionals matters and how they can support you:

Hire a Commercial Real Estate Agent

A commercial real estate agent specializes in finding and securing properties that match your investment goals. Unlike residential agents, commercial agents understand the complexities of zoning laws, tenant agreements, and market trends.

How They Help:

• Market Insights: Agents have access to market data and off-market listings, helping you spot undervalued properties.
• Negotiation Skills: A skilled agent can negotiate better terms, including purchase price, closing costs, and lease agreements.
• Property Evaluation: They can identify red flags, such as poor location or structural issues, before you commit.

Consult with a Real Estate Attorney

A real estate attorney ensures that all legal aspects of the transaction are handled correctly. Commercial deals involve complex contracts, zoning regulations, and lease agreements that need expert review.

How They Help:

• Contract Review: Attorneys ensure the purchase agreement protects your interests and highlights any hidden liabilities.
• Title Search: They confirm the property’s ownership status and uncover any existing liens or disputes.
• Compliance: Attorneys verify that the property meets local zoning and building codes.

Hire a Property Inspector

A detailed property inspection helps you avoid unexpected repair costs and legal issues. Commercial properties often have more complex systems—like HVAC, electrical, and plumbing—than residential ones.

How They Help:

• Identify Repairs: Inspectors find issues that could impact the property’s value or safety.
• Estimate Costs: They provide repair cost estimates, helping you negotiate a lower price or plan for future expenses.
• Ensure Code Compliance: Inspectors confirm that the property meets building and safety codes.

Work with a CPA (Certified Public Accountant)

Commercial real estate investments come with complex tax implications. A CPA helps you structure your investment to minimize tax liabilities and maximize profits.

How They Help:

• Tax Strategy: CPAs advise on depreciation, deductions, and capital gains treatment.
• Financial Projections: They provide cash flow models to estimate future profits and expenses.
• Record Keeping: CPAs ensure that income and expenses are properly recorded for tax reporting.

Consider Flexibility and Scalability

When investing in commercial real estate, it’s important to think about the future. A property that works well for your current needs might not be the right fit a few years down the line. That’s why flexibility and scalability should be key factors in your decision-making process. Choosing a property that can adapt to changing market conditions, tenant demands, and business growth gives you an advantage and protects your investment over time.

Look for Adaptable Property Design

A property with a flexible design can accommodate different types of tenants and uses. This increases your chances of keeping the property occupied and generating steady income.

Key Features to Look For:

• Open floor plans – These allow tenants to customize the space for their specific needs.
• Modular design – Spaces that can be easily divided or combined offer more leasing options.
• High ceilings and wide doorways – These make it easier to convert the space for different uses, such as retail, office, or warehouse.

Assess the Potential for Expansion

A property that allows for physical expansion can grow with market demand or business growth. This increases long-term value and rental income potential.

How to Evaluate Expansion Potential:

• Zoning laws – Check if local zoning regulations allow for vertical or horizontal expansion.
• Available land – A property with extra land can be developed to increase rentable space.
• Building structure – Some buildings are designed to support additional floors or extensions.

Plan for Market Fluctuations

The commercial real estate market is cyclical. A flexible and scalable property allows you to adapt during both strong and weak markets.

How to Protect Against Market Changes:

• Mixed-use spaces – Properties with a mix of residential, retail, and office spaces can weather market shifts better.
• Alternative revenue streams – Parking fees, event space rentals, and advertising opportunities can provide extra income when leasing demand is low.
• Energy efficiency and sustainability – Properties with eco-friendly features (like solar panels and smart lighting) are more attractive to tenants and can reduce operating costs.

Identifying and Assessing Risks

Commercial real estate can be a profitable investment, but it comes with its share of risks. Understanding and managing these risks is key to protecting your investment and ensuring long-term success. Smart investors know how to identify potential pitfalls and put strategies in place to reduce their impact.

Market Risk

Market conditions can change quickly, affecting property values and rental demand. Economic downturns, shifts in consumer behavior, and local market trends all impact the value and profitability of commercial real estate.

How to Manage Market Risk:

• Diversify your portfolio – Investing in different property types (like retail, office, and industrial) reduces exposure to a single market’s ups and downs.
• Research market trends – Study supply and demand, vacancy rates, and rental trends in the area.
• Invest in growing areas – Locations with population growth, business development, and infrastructure improvements tend to be more stable.

Tenant Risk

The success of a commercial property often depends on the strength and reliability of the tenants. If a major tenant leaves or defaults on their lease, it can create cash flow problems and increase vacancy rates.

How to Manage Tenant Risk:

• Screen tenants carefully – Check credit scores, business history, and financial stability.
• Diversify tenant types – A mix of retail, office, and service tenants reduces dependence on any one type of business.
• Negotiate long-term leases – Secure longer lease terms with established tenants to create income stability.

Financial Risk

Financing commercial properties often involves larger loans and higher interest rates. Poor financial planning can lead to cash flow issues and even foreclosure.

How to Manage Financial Risk:

• Maintain a cash reserve – Keep extra funds on hand to cover unexpected expenses or vacancies.
• Secure favorable loan terms – Shop around for competitive interest rates and loan terms.
• Create a detailed budget – Include maintenance costs, property taxes, insurance, and potential upgrades in your financial plan.

Operational Risk

Managing a commercial property comes with ongoing costs and responsibilities. Poor property management can lead to maintenance issues, unhappy tenants, and higher vacancy rates.

How to Manage Operational Risk:

• Hire a professional property manager – Experienced managers handle tenant relationships, maintenance, and lease agreements.
• Schedule regular maintenance – Keeping the property in good condition prevents expensive repairs and attracts quality tenants.
• Monitor expenses closely – Track operating costs and identify areas where you can cut back without compromising quality.

Legal and Regulatory Risk

Zoning laws, building codes, and tax regulations can change over time, impacting how you can use or modify your property. Legal issues with tenants or contractors can also create unexpected costs.

How to Manage Legal and Regulatory Risk:

• Stay informed about local laws – Work with a real estate attorney to ensure compliance with zoning, licensing, and tenant laws.
• Use clear lease agreements – Clearly outline tenant responsibilities and terms to avoid disputes.
• Obtain proper insurance – Protect against liability, property damage, and natural disasters with a comprehensive insurance policy.

Ready to invest?

Understanding the rule in real estate investing is key to making profitable decisions. Whether you’re a seasoned investor or new to the field, there are multiple ways to invest in real estate.

Want to learn more about maximizing investment returns and identifying prime investment opportunities? Schedule a consultation to explore how you can optimize your real estate portfolio and make informed investment choices.

Selling an investment property often comes with a big tax bill. But what if you could defer those taxes and still keep a stake in real estate? That’s exactly what a 721 exchange allows.

With this strategy, you can trade your physical property for shares in a REIT—giving you access to a diversified portfolio while avoiding the headaches of direct ownership and enjoying tax deferral. 

Let’s explore how it works and whether it’s right for you.

How Does 721 Exchange Work? 

A 721 exchange, also known as an UPREIT (Umbrella Partnership Real Estate Investment Trust) transaction, allows real estate investors to convert their property holdings into shares of a Real Estate Investment Trust (REIT) while deferring capital gains taxes.

This process happens in two primary steps:

1. A 1031 Exchange into a Delaware Statutory Trust (DST)
2. A 721 Exchange into REIT Operating Partnership (OP) Units

It is important to note that a 721 exchange is not guaranteed—REITs have the discretion to acquire DST assets, but investors should not assume that an exchange will occur. Now, let’s break the 721 exchange process down step by step.

Step 1: 1031 Exchange into a DST

A 1031 exchange is a well-known strategy that allows investors to defer capital gains taxes by reinvesting the proceeds from a sold property into another qualifying real estate investment. In this case, instead of purchasing another physical property, the investor acquires fractional ownership in a Delaware Statutory Trust (DST).

What Happens in This Step?

1. Investor Sells Their Investment Property
   • The investor sells their real estate (a rental property, commercial asset, or other investment property).
   • They defer capital gains taxes by using the proceeds to complete a 1031 exchange.
2. Investor Acquires Ownership in a DST
   • Instead of purchasing a new physical property, the investor acquires a fractional interest in a DST.
   • The DST is a passive real estate investment vehicle where multiple investors own shares in an institutional-quality property portfolio.
   • The investor has no landlord responsibilities—all management is handled by the DST sponsor.
3. Investor Begins Receiving Passive Income
   • The investor receives quarterly distributions from the DST.
   • The amount received depends on the cash flow of the underlying properties.
4. Holding Period in the DST
   • The investor typically holds the DST investment for at least two years, though the actual timeline may vary based on market conditions and sponsor decisions.
   • During this period, the REIT’s Operating Partnership (OP) may choose to exercise its option to acquire the investor’s DST shares.
   • If this happens, the investor transitions into Step 2: The 721 Exchange Process.

Step 2: 721 Exchange into REIT Operating Partnership (OP) Units

After holding the DST investment for at least two years, the REIT’s Operating Partnership (OP) may exercise its option to purchase the DST assets, allowing for potential tax deferral. If this occurs, the investor’s beneficial interest in the DST converts into operating partnership units in the REIT’s operating partnership, which can be advantageous for estate planning.

What Happens in This Step?

1. Investor Exchanges DST Shares for OP Units
   • The REIT’s Operating Partnership exercises its Fair Market Value (FMV) Option to acquire the DST’s properties, which can have favorable tax consequences.
   • Investors in the DST receive Operating Partnership (OP) Units in return for their fractional DST ownership.
2. Ownership in a Diversified REIT Portfolio
   • The investor now owns operating partnership units, which provide fractional ownership in the REIT’s entire portfolio of properties, offering significant tax advantages.
   • This portfolio consists of institutional-grade, professionally managed real estate across multiple asset classes and locations.
3. Investor Begins Receiving Monthly Distributions
   • Unlike the DST, which may provide quarterly distributions, REIT OP Units may offer distributions, which are subject to the REIT’s performance and management decisions.
   • This income comes from rental revenue and property appreciation in the REIT’s portfolio.
4. Mandatory One-Year Holding Period
   • The investor must hold OP Units for at least one year before making any changes.
   • During this time, the investment continues to generate passive income and potential capital appreciation.

Step 3: Investor's Options After the One-Year Holding Period

Once the one-year holding period for operating partnership units is complete, the investor can choose from the following options for tax deferral:

Option 1: Hold OP Units and Continue Receiving Income

• The investor can retain OP Units indefinitely.
• As long as the investor holds OP Units, they continue receiving passive income distributions.
• The value of OP Units may fluctuate based on the REIT’s performance and market conditions

Option 2: Convert OP Units into REIT Common Shares or Cash

• The investor can convert OP Units into REIT Common Shares if they prefer liquidity.
• REIT Common Shares can be traded on the stock market (if the REIT is publicly listed), providing more flexibility.
• Alternatively, the investor can redeem OP Units for cash, though this would trigger capital gains taxes on the amount sold.

Option 3: Sell OP Units or REIT Shares

• The investor may choose to sell OP Units or REIT Common Shares at any time after the holding period.
• If sold, capital gains taxes apply on the amount sold within the tax year.
• However, if OP Units or REIT Shares are held until passing, the investor’s heirs receive a step-up in basis, potentially reducing future tax liabilities.

Note: Once an investor converts their DST interest into REIT OP Units via a 721 exchange, they are no longer eligible to participate in a future 1031 exchange. This is an important consideration for those who may want to continue deferring taxes indefinitely through 1031 exchanges.

Is a 721 Exchange Right for You?

A 721 exchange is a powerful wealth-building tool for real estate investors who want to transition from direct ownership to passive investing while deferring taxes.

However, it’s not for everyone. Investors who value direct control, frequent 1031 exchanges, or immediate liquidity should weigh the risks carefully. If your goal is diversification, passive income, and long-term tax efficiency, a 721 exchange into a REIT’s OP Units may be an excellent option.

Thinking about a 721 exchange? Contact us now to see if it’s right for you!

What if you could exchange your real estate for ownership in a professionally managed real estate portfolio while deferring capital gains taxes? 

A 721 Exchange allows you to do exactly that—provided the transaction follows IRS rules. This strategy allows investors to trade real estate for REIT ownership, unlocking diversification, passive income, and tax deferral. However, taxes are deferred, not eliminated, and become payable upon conversion of OP Units into REIT shares.

Here are key rules you need to know before making the move. Let’s break it down.

Key Rules & Requirements of a 721 Exchange

A 721 Exchange helps real estate investors defer capital gains taxes. It works by swapping a property for Operating Partnership (OP) Units in an UPREIT (Umbrella Partnership Real Estate Investment Trust). This strategy lets investors move from direct property ownership to passive real estate investment while diversifying their portfolio.

But not all properties qualify. Strict rules apply, and investors must follow specific guidelines. Below, we break down the key requirements, ownership structures, and restrictions to know before using a 721 Exchange.

What Types of Properties Qualify for a 721 Exchange?

For a 721 Exchange to be eligible, the property must meet certain criteria. This exchange lets investors defer taxes, but not all properties are eligible. Only certain types can be converted into Operating Partnership (OP) Units. Understanding these limits is key to making the most of this strategy.

Eligible Properties:

• Investment Real Estate – Investment real estate, such as rental properties, commercial buildings, and multi-family units typically qualify for a 721 Exchange. 
• Income-Producing Assets – The property should generate ongoing income. For example, multi-family apartment buildings, shopping centers, or office buildings that produce rental income.

Ineligible Properties:

• Personal-use Property – Your primary residence, second homes, or vacation homes are not eligible for a 721 Exchange. The exchange only applies to real estate held for investment purposes.
• Raw Land – While some UPREITs may accept land, others may not. If you are thinking about exchanging vacant land or land that isn’t generating rental income, be sure to confirm whether it meets the eligibility requirements of the UPREIT.

To qualify, you must exchange your property for Operating Partnership (OP) Units in an UPREIT. Once exchanged, you no longer own physical real estate. Instead, you hold shares in the REIT's portfolio.

One key rule: You must contribute the property directly to the UPREIT. A 1031 Exchange won’t work once you convert to REIT shares.

Rules for exchanging real estate for OP Units

The 721 Exchange isn’t about selling property for cash. Instead, it’s about converting real estate into Operating Partnership (OP) Units. Here’s how it works:

• Direct Property Contribution – In a 721 Exchange, you transfer ownership of your real estate property to a UPREIT. In return, you receive OP Units, which give you ownership in the REIT, not the individual properties.
• Tax Deferral – The IRS allows you to defer capital gains taxes on your property sale, as long as you exchange it for OP Units instead of cash or other property. This is similar to a 1031 Exchange, but instead of swapping one property for another, you’re entering a new form of investment.
• No Boot Allowed – Unlike a 1031 Exchange, a 721 Exchange has a key restriction: no “boot.” Boot is cash or non-qualifying property. In a 721 Exchange, everything must be property for property. If you receive cash, it triggers capital gains taxes.

By contributing your property to an UPREIT, you defer taxes and shift from owning property directly to holding OP Units in a REIT. However, distributions are not guaranteed, and you lose control over property management and sales decisions. Your returns depend on the REIT’s performance and market conditions.

Understanding ownership structure and restrictions

Once you complete the 721 Exchange, you no longer directly own the physical property. Instead, you own OP Units in the REIT, which gives you exposure to the REIT’s portfolio of properties. Here's what to know about the ownership structure and its restrictions:

• Ownership of OP Units – OP Units work like shares of stock, but instead of owning a single property, you own a fraction of a professionally managed real estate portfolio. Your investment grows or declines based on the REIT’s overall performance rather than a single property’s value.
• Loss of Direct Control – In a 721 Exchange, you give up the ability to make individual property decisions. Unlike when you own real estate directly, the REIT’s management team makes decisions about property sales, acquisitions, and management. You no longer have any say in how individual properties are managed or sold.
• Dividends and Distributions – As an investor in the REIT, you can receive regular income payments (dividends) based on the performance of the REIT’s properties. These payments are often made quarterly or monthly.
• Limited Liquidity – OP Units are not publicly traded and cannot be sold like traditional stocks. While some UPREITs allow conversions into REIT shares after a lock-up period (typically one to two years), timing and liquidity options depend on the specific REIT's policies. Investors should carefully evaluate the liquidity constraints before entering a 721 Exchange.

While you gain passive income, it’s important to understand that you are no longer actively managing the investment. This is a trade-off between diversification and control.

Lock-in periods and when investors can convert OP Units into REIT shares

After you exchange your real estate for OP Units in a 721 Exchange, you may be wondering when you can turn those OP Units into REIT shares. Here’s what you need to know about the lock-in periods and conversion rules:

• Lock-In Period – Most UPREITs require investors to hold their OP Units for a certain period of time—typically one to two years—before they can convert those units into publicly traded REIT shares. This lock-in period ensures that the REIT’s investors are committed long-term and provides the REIT with stability.
• Conversion to REIT Shares – After the lock-up period, investors may have the option to convert OP Units into publicly traded REIT shares. However, this conversion triggers capital gains taxes, which are calculated based on the property's original cost basis and appreciation. Investors should consult a tax professional to evaluate their individual tax liability.
• Tax Implications of Conversion – When OP Units are converted into REIT shares, the tax deferral ends. You’ll be required to pay capital gains tax on the appreciation of your property from the time you acquired it until the time of conversion. It’s important to understand that taxes are only deferred, not eliminated.

Understanding the lock-in period and conversion rules is critical for planning your investment strategy. If you are relying on the income from the REIT, you may not want to convert your OP Units into shares too quickly. On the other hand, if you need liquidity, you’ll want to make sure you’re prepared for the conversion after the lock-up period expires.

Ready to Take the Leap?

Shifting from hands-on property management to passive investing is a big step. A 721 Exchange can help you defer taxes and diversify your portfolio. But it also has risks—like liquidity limits and tax liabilities when you convert.

Before making a move, speak with a tax or financial advisor to see if this strategy fits your goals.

Want to explore your options? Contact our team today.

Selling an investment property can mean a hefty tax bill. But what if there was a way to defer taxes while transitioning into a different real estate investment structure?

That’s where a 721 Exchange comes in. This strategy allows you to swap real estate for shares in a Real Estate Investment Trust (REIT), offering potential liquidity and hassle-free ownership.

But is it the right move for you? In this article, we’ll explore what a 721 Exchange offers, its limitations, and how to decide if it’s the right path for your investment strategy.

What Is a 721 Exchange?

A 721 Exchange is a tax-deferred strategy that allows real estate investors to swap their property for ownership in a Real Estate Investment Trust (REIT). Instead of selling your property and paying capital gains taxes, you contribute it to an Umbrella Partnership Real Estate Investment Trust (UPREIT).

In return, you receive Operating Partnership (OP) Units, which act like shares in the REIT. Over time, you can convert these units into publicly traded REIT shares, giving you liquidity and diversification.

The biggest advantage? You transition from hands-on property management to completely passive ownership—without an immediate tax hit.

Pros of a 721 Exchange

Tax Deferral

A key advantage of a 721 Exchange is the potential to defer capital gains taxes. However, tax deferral is subject to compliance with IRS regulations and could result in future tax liabilities. Investors should consult a tax advisor to understand the long-term implications.

When you sell an investment property the traditional way, the IRS takes a big cut in the form of capital gains taxes. But with a 721 Exchange, you contribute your property to a Real Estate Investment Trust (REIT) instead of selling it outright.

Since this is a like-kind exchange, the IRS allows you to defer taxes on your gains. That means more of your money stays invested and working for you rather than going to the government. Over time, this can significantly increase your overall returns. However, future tax liabilities may apply when OP Units are converted into publicly traded REIT shares.

Passive Ownership 

Tired of dealing with tenants, maintenance, and property management? A 721 Exchange lets you step away from active real estate management and move into fully passive investing.

After exchanging your property for Operating Partnership (OP) Units, the REIT management team assumes control of property operations, including leasing, maintenance, and sales. No more late-night repair calls. No more worrying about vacancies. Just hands-off investing with professional management. While this provides passive ownership, returns are not guaranteed and will depend on the REIT’s performance and market conditions.

Diversification

Instead of having all your wealth tied up in a single property, a 721 Exchange lets you spread your investment across a diverse portfolio of properties.

REITs typically own high-value commercial properties like office buildings, apartment complexes, shopping centers, and industrial facilities. When you exchange your property, you become a part-owner of this portfolio. This diversification reduces risk and provides more stable, long-term returns compared to owning a single property.

Even if one sector underperforms, the diversified nature of a REIT’s holdings may help mitigate individual asset risks. However, diversification does not guarantee profit or protection against losses.

Potential Liquidity

Real estate investments are traditionally illiquid, meaning it’s hard to sell quickly if you need cash. But a 721 Exchange offers a path to liquidity. Upon completing a 721 Exchange, investors receive Operating Partnership (OP) Units, which are not immediately tradable. 

Over time, and subject to REIT policies, these units may be converted into publicly traded REIT shares. This means you can eventually turn your real estate into a liquid, tradable investment—a major advantage for investors who want both long-term stability and financial flexibility.

However, liquidity is not guaranteed, and conversion policies vary by REIT. Investors should carefully evaluate the holding period requirements before proceeding.

Estate Planning Benefits 

Passing down investment properties can be complicated. Estate taxes and management hassles often burden heirs. A 721 Exchange helps simplify this process.

Instead of leaving behind physical properties, you pass down Operating Partnership (OP) Units—a far easier asset to inherit. Your heirs won’t have to worry about managing tenants, handling maintenance, or selling real estate. Plus, when they inherit OP Units, the cost basis resets to the current market value. This can eliminate capital gains taxes that would otherwise apply if the property were sold during your lifetime.

This strategy makes a 721 Exchange a powerful tool for estate planning. It allows you to pass on wealth without passing on headaches. However, tax treatment varies based on current laws and personal circumstances. To fully understand the implications, investors should consult an estate planning professional.

Cons of a 721 Exchange

No Future 1031 Exchanges

A 1031 Exchange allows real estate investors to defer capital gains taxes by rolling profits into another investment property. But once you complete a 721 Exchange, you lose that ability.

Here’s why: When you contribute your property to a Real Estate Investment Trust (REIT), you receive Operating Partnership (OP) Units instead of real estate. While these units can later convert into REIT shares, the IRS does not consider them “like-kind” real estate. This means that once you convert your OP Units to publicly traded REIT shares, you can no longer do a 1031 Exchange.

If keeping the option for future tax-deferred exchanges is important to you, a 721 Exchange might not be the best fit. However, some REITs offer structured programs that may provide alternative tax-deferral options.

Illiquidity (Initially)

Unlike publicly traded REIT shares, Operating Partnership (OP) Units) are not immediately liquid. This means that while you’ve transitioned into a passive investment, you won’t be able to sell your OP Units right away if you need quick access to cash.

Most REITs require investors to hold OP Units for a certain period before converting them into publicly traded shares. The timeline can vary depending on the REIT’s policies, but it’s often several years.

If liquidity is a top priority, be sure to understand the conversion timelines before moving forward with a 721 Exchange.

Limited Control

When you own a property, you have full control—you decide when to sell, who to rent to, and how to manage expenses. In a 721 Exchange, all of that changes.

Once you contribute your property to a REIT, the REIT’s management team makes all the investment decisions. They handle everything from property selection to leasing, maintenance, and selling assets. While this is great for hands-off investing, it also means you lose control over your investment.

If you prefer to have a direct say in how your real estate is managed, this might be a major drawback.

Potential Tax Consequences

While a 721 Exchange helps you defer capital gains taxes when you contribute your property, future tax liabilities can still arise.

Here’s how:

• When you convert OP Units into REIT shares, the IRS recognizes this as a taxable event. That means you may owe capital gains taxes at the time of conversion.
• Dividends from REIT shares are taxed as ordinary income, which can be higher than the tax rate on long-term capital gains.

This means that while a 721 Exchange helps you defer taxes initially, it doesn’t eliminate them completely. Planning ahead is crucial to avoid unexpected tax bills down the road. Investors should consult a tax professional to understand their specific tax liabilities.

REIT Risks 

REITs provide diversification and professional management, but they still carry market risks.

Unlike direct real estate ownership, where values tend to move slowly, publicly traded REIT shares can fluctuate based on stock market conditions. This means that even if the underlying real estate is performing well, external market factors—such as interest rate changes, economic downturns, or investor sentiment—can affect your share value.

If you plan to hold your investment long-term, this may not be a major concern. But if market volatility worries you, a 721 Exchange may not be the right fit. Investors should assess their risk tolerance before committing to a 721 Exchange.

Who Should Consider a 721 Exchange?

A 721 Exchange isn’t the right fit for everyone. But for the right investor, it can be a powerful wealth-building strategy that simplifies real estate ownership while keeping money invested.  Here’s who benefits the most:

Investors Looking to Consolidate and Simplify

Managing multiple properties takes time, effort, and resources. If you’ve recently sold off some real estate or want to reduce the hassle of owning many properties, a 721 Exchange can help.

Why it works: Instead of handling multiple properties, you transition into a diversified real estate portfolio without triggering immediate tax bills.

Best for: Investors looking to streamline holdings and reduce the burden of active property management.

Investors Who Want to Defer Capital Gains Taxes

Selling real estate can mean huge capital gains taxes. But a 721 Exchange lets you defer those taxes and keep your money growing inside a REIT.

Why it works: Just like a 1031 Exchange, you avoid immediate taxes by rolling your property into a professionally managed REIT.

Best for: Investors who want to sell without a massive tax hit and reinvest in real estate.

Investors Who Want a Break from Property Management

Are you tired of tenants, repairs, and unexpected expenses? A 721 Exchange lets you step away from hands-on management and shift into passive ownership.

Why it works: By exchanging your property for Operating Partnership (OP) Units, you gain exposure to a professionally managed real estate portfolio—no landlord duties required.

Best for: Investors looking for passive income while eliminating landlord headaches.

Investors Looking for Diversification

Owning a single property—or even a handful—concentrates your risk in one market. A 721 Exchange helps you spread out that risk by converting your holdings into a diverse REIT portfolio.

Why it works: REITs own multiple property types across different locations, offering more stability than investing in just one or two properties.

Best for: Investors who want to reduce risk and gain exposure to a broader range of real estate assets.

Investors Seeking Reliable Passive Income

If you’re seeking an alternative to active property management, a 721 Exchange allows for potential passive income. However, income distributions are subject to REIT performance and are not guaranteed.

Why it works: Investors may receive periodic income distributions from the REIT’s revenue-generating assets. However, these payments are subject to REIT performance and are not guaranteed.

Best for: Investors who want a consistent income stream without day-to-day involvement in real estate.

Who Should Avoid a 721 Exchange?

A 721 Exchange offers tax deferral, passive income, and diversification, but it’s not the right fit for everyone. Here’s who should think twice before making the move:

Investors Who Want to Keep Using 1031 Exchanges

Once you complete a 721 Exchange, you can no longer do a 1031 Exchange in the future. That means you lose the ability to keep deferring taxes through property swaps.

Why it’s a problem: If you prefer rolling your real estate profits into new properties instead of REIT shares, a 1031 Exchange is the better choice.

Who should avoid it? Investors who want to keep trading properties while deferring taxes.

Investors Who Need Immediate Liquidity

A 721 Exchange doesn’t give you cash right away. Instead, you receive Operating Partnership (OP) Units, which are not immediately tradable.

Why it’s a problem: OP Units must be held for a certain period before they can be converted into REIT shares and sold. If you need quick access to cash, this strategy may not work for you.

Who should avoid it? Investors who need immediate liquidity or plan to cash out soon.

Investors Who Want Full Control Over Their Assets

When you swap your property for REIT shares, you give up decision-making power. The REIT management team handles acquisitions, leasing, and sales—you just collect dividends.

Why it’s a problem: If you enjoy making investment decisions, managing properties, and having full control, a 721 Exchange might feel too restrictive.

Who should avoid it? Hands-on investors who prefer managing their own real estate portfolio.

Investors Concerned About Market Volatility

REIT shares fluctuate with the stock market, meaning their value can rise or fall based on economic conditions, interest rates, and investor sentiment.

Why it’s a problem: Unlike physical real estate, REIT values can be affected by market downturns, potentially leading to losses. If you want stable property ownership, this may not be the right move.

Who should avoid it? Investors who prefer real estate’s long-term stability over market-driven fluctuations.

Investors Who Want Predictable Tax Outcomes

A 721 Exchange allows for tax deferral, but when you eventually convert OP Units into REIT shares and sell them, capital gains taxes and income tax may apply.

Why it’s a problem: Depending on how long you hold the shares, you could face unexpected tax consequences when cashing out.

Who should avoid it? Investors who want full clarity on future tax obligations before making a move.

Final Thought: Is a 721 Exchange Right for You?

A 721 Exchange offers tax deferral, passive income, and diversification. But it also comes with trade-offs. Once you convert Operating Partnership (OP) Units into REIT shares, you lose the ability to do a 1031 Exchange. This means you may face future tax liabilities when you sell your shares.

Unlike direct real estate ownership, REIT investments are tied to the stock market. Their value can rise or fall based on market trends, interest rates, and economic conditions. Plus, you won’t control property decisions—REIT management handles acquisitions, sales, and operations.

Before deciding, speak with a tax professional, financial advisor, or estate planner. Make sure a 721 Exchange fits your long-term investment goals and financial plan.

If you’re considering a 721 Exchange and want to explore your options, contact Stax Capital today to discuss your next steps.