What Is a 721 Exchange? Benefits, Risks, and Key Considerations

For many real estate investors, the 1031 exchange has been the go-to strategy for years. But there’s another option on the table that could help you defer taxes and build wealth in a different way—the 721 exchange. 

What exactly is it? How can it benefit your investment strategy? And what should you watch out for? This blog will walk you through everything you need to know about the 721 exchange so you can make informed decisions for your portfolio.

What Is a 721 Exchange?

A 721 exchange, also known as an UPREIT (Umbrella Partnership Real Estate Investment Trust) exchange, is a strategy that lets real estate investors swap their property for units in an operating partnership (OP). These units can later be converted into shares of a Real Estate Investment Trust (REIT). This strategy offers a major advantage: the ability to defer capital gains taxes that would typically be owed on a property sale.

The best part? You don’t pay taxes until you redeem your shares, and you have the flexibility to redeem them over time to potentially benefit from lower tax rates. Plus, by diversifying into REITs, you gain access to professional management and liquidity—things that are harder to achieve with direct property ownership.

Benefits of a 721 Exchange

A 721 exchange offers a range of benefits for real estate investors looking to make strategic moves with their assets. The primary advantages of a 721 exchange vary based on the structure and agreements in place, but the potential rewards are significant. Below are the key benefits of performing a 721 transaction:

Passive Income Generation

Managing real estate properties can be time-consuming and demanding. Property investors often take an active role, even when hiring property managers for daily operations. They must handle rental income fluctuations, absorb potential losses, and make key decisions about the property’s future.

A 721 exchange simplifies this process. Investors exchange direct ownership for units in an operating partnership (UPREIT). This shift relieves them of property management duties. The UPREIT manager oversees the asset portfolio and distributes income to unitholders.

This arrangement offers the potential for passive income without the responsibilities of active property management. However, income distributions are not guaranteed and depend on the performance of the REIT.

Tax Advantages and Deferral

One of the standout benefits of a 721 exchange is the tax deferral. When real estate is sold traditionally, it triggers a taxable event, meaning the IRS collects taxes on capital gains and depreciation recapture, reducing the sale profits. If the investor wants to reinvest, this tax burden can eat into their purchasing power.

With a 721 exchange, no taxable event occurs upon transferring property to the operating partnership. Instead, taxes are deferred until the investor sells their units in the OP or converts them into REIT shares. This may provide flexibility in managing taxes and preserving capital for potential future investment opportunities. However, taxes will be owed when REIT shares are sold or liquidated, and investors should plan accordingly.

Increased Liquidity

Real estate is often considered an illiquid investment. This is because selling properties for cash can be difficult and time-consuming. Besides, factors like market conditions, financing processes, and the need for appraisals or inspections can all delay a property sale. As a result, these factors leave investors with assets tied up for extended periods.

A 721 exchange helps to increase liquidity by allowing investors to trade their property for units in an operating partnership. These units can later be converted into REIT shares. This gives investors quick access to cash and allows them to reallocate capital as needed.

Non-listed and private REIT shares may be less liquid. However, publicly traded REIT shares offer a level of flexibility that physical real estate cannot match. This added liquidity makes a 721 exchange a valuable tool for real estate investors seeking greater financial freedom.

Diversification Across Sectors and Geographies

Diversification is a key strategy to manage risk and reduce the effects of market ups and downs. When you own a single real estate property, all your investment is tied to that one asset. However, with a 721 exchange, investors gain access to the diversified portfolio of assets held by the REIT.

It allows you to trade one property for units in a REIT, giving you access to a diversified portfolio. REITs often invest in various properties across different regions and sectors. These can include healthcare, self-storage, retail, and more. Some REITs go further by diversifying across multiple industries.

This broader approach spreads risk and reduces dependency on one asset or sector. By moving from direct property ownership to REIT units, you can achieve diversification without buying multiple properties. It's a smart way to lower risks and enhance the potential for steady returns.

Simplified Estate Planning

Estate planning can be complicated when real estate properties are involved. Transferring property to heirs may require selling the property, dividing it, or managing family disagreements over the asset. This can be a challenging and stressful process.

A 721 exchange simplifies estate planning by allowing investors to pass their assets to their heirs with ease. After the investor’s death, the units held in the operating partnership can be converted into REIT shares and divided equally among heirs. Unlike real estate, REIT shares are more easily liquidated, providing heirs with a more straightforward and efficient way to handle the inheritance. 

Additionally, heirs will receive a step-up in basis, which means the value of the shares for tax purposes will be the fair market value on the date of the investor’s death rather than the original purchase price. This step-up in basis may reduce the taxable liability for heirs, though specific tax outcomes depend on individual circumstances and should be discussed with a qualified tax advisor.

Risks of a 721 Exchange

While a 721 exchange can offer many advantages, it’s important to be aware of the potential risks and drawbacks that come with this type of real estate transaction. A full understanding of these risks is essential to making an informed decision. Below are the key risks to consider when engaging in a 721 exchange:

Limited Control Over the Investment

A key downside of a 721 exchange is losing direct control over your property. In a traditional real estate investment, you make decisions about the property, its management, and its future. But in a 721 exchange, you trade ownership for units in an operating partnership (UPREIT). This means you become a unitholder instead of a direct property owner.

While you still have a financial stake in the real estate through the REIT, control shifts to the REIT’s management team. They oversee the properties in the portfolio and make day-to-day decisions. As a unitholder, your influence is limited to voting on significant matters like leadership changes or major policy updates. If you prefer having direct control over your investments, this may not be the ideal move for you.

Tax Complexity

A 721 exchange offers the appealing advantage of deferring capital gains taxes on the sale of your property. However, this deferral can come with added tax complexity. While the immediate sale of property may be tax-free, it’s important to understand that the tax treatment of the REIT units or shares you receive can be complicated.

Dividends from REITs, which are typically paid to shareholders, may be subject to income tax and can affect your overall tax situation. The tax implications of receiving these dividends or selling your REIT shares are often different from the taxes you would encounter if you were to directly sell your property. This can make your tax situation more complicated and may require professional advice to navigate properly.

Liquidity Constraints

While REITs generally offer more liquidity than direct real estate investments, there can still be limitations when it comes to converting your shares into cash. Some UPREITs impose restrictions on how and when you can redeem your units for cash or convert them into REIT shares. These restrictions may vary depending on the specific terms of the REIT and the market conditions.

For example, some UPREITs may only allow you to sell or convert your units at certain times or under certain conditions, which can limit your ability to access cash when you need it most. If you’re looking for flexibility in accessing funds, these constraints could pose a challenge.

Exit Strategy Challenges

Exiting a 721 exchange investment can be tricky. Unlike selling property directly, cashing out typically involves selling or converting your units into REIT shares. This process could trigger capital gains tax on any increase in the value of your shares.

Additionally, if you wish to sell your REIT shares, you may face market fluctuations that affect the price, meaning you might not be able to sell your shares at a price you’re satisfied with. Unlike direct real estate ownership, where sales can involve negotiations, REIT share prices are subject to market fluctuations. This can affect both the timing and profitability of your exit strategy.

Key Considerations Before Proceeding

A 721 exchange offers unique benefits, but it's not a one-size-fits-all solution. Before moving forward, it’s essential to evaluate whether this type of transaction aligns with your investment goals, financial situation, and risk tolerance. Here are key factors to consider:

Understand the Long-Term Commitment

A 721 exchange often represents a long-term shift in your investment strategy. Once your property is exchanged for REIT units, reversing the transaction isn’t an option. Ensure you’re comfortable with the transition from direct ownership to being a passive investor, and evaluate how this fits into your long-term financial plans.

Evaluate the Liquidity of Your Investment

While REITs typically offer more liquidity than direct property ownership, there are still limitations. Some REITs impose restrictions on selling units or converting them into cash. Publicly traded REIT shares are more liquid than private REITs, but their value is subject to market conditions. Consider your need for immediate access to funds before committing to a 721 exchange.

Assess Your Control Preferences

Transitioning from direct ownership to REIT units means relinquishing control of property management. The REIT’s management team will oversee operations and decisions, limiting your influence. If having direct control over investment decisions is important to you, a 721 exchange may not be the ideal path.

Understand the Tax Implications

The tax advantages of a 721 exchange are appealing. You can defer capital gains taxes, which is a big benefit. However, the tax treatment of REIT dividends and share conversions can get complicated. Therefore, it’s important to consult with a tax professional. They can help you understand how a 721 exchange impacts your taxes, especially when planning to sell your REIT shares in the future.

Consider Diversification Benefits

One of the major advantages of a 721 exchange is the potential for portfolio diversification. REITs often invest in a range of asset types, industries, and geographic locations. Assess whether this aligns with your risk management strategy and complements your existing investments.

Research the REIT’s Performance

Before committing to a 721 exchange, carefully evaluate the REIT’s track record, financial stability, and asset portfolio. Research the management team, historical performance, and future growth potential. Aligning with a reputable REIT can mitigate some risks and improve your investment experience.

Plan Your Exit Strategy

While a 721 exchange allows for tax deferral, eventual liquidation of REIT units or shares may trigger a taxable event. Additionally, market volatility can affect the timing and profitability of your exit. Develop a clear strategy for how and when you plan to cash out to avoid unexpected financial consequences.

Examine the Legal and Financial Terms

Carefully review the legal agreements and financial terms of the 721 exchange and the REIT. Ensure that you fully understand the restrictions, fees, and potential scenarios outlined in the agreements. Consulting with legal and financial advisors can help you identify any red flags.

Is a 721 Exchange Right for You?

Navigating the world of real estate investment requires careful consideration of your options. A 721 exchange can be a powerful tool, but only when aligned with your financial goals and risk tolerance. Don’t leave your decisions to chance—reach out to our team for expert insights and tailored solutions.