What is the 721 Exchange or ‘UPREIT’?
Most real estate investors are familiar with the 1031 exchange & the ability to defer tax on real estate sales by transferring that equity to a “like kind” property. It has provided investors with a simple way to defer, not dodge, capital gains tax since its inception in 1928.
A lesser know opportunity to defer capital gains taxes, the 721 exchange – also referred to as an UPREIT – provides a route by which the property owner can exchange their property for equity units in the UPREIT.
This structure allows investors to sell their property & invest in a fractional ownership of a real estate portfolio instead of individual property. There are significant benefits to transferring real estate equity into a portfolio including access to class A properties, stellar management teams, monthly income, & diversified risk
What is an UPREIT?
UPREIT stands for Umbrella Partnership Real Estate Investment Trust.
First established in 1960, Real Estate Investment Trusts (REITs) comprise of a portfolio of income-generating real estate investments, allowing shareholders to invest in real estate without directly purchasing any singular property.
More than providing access to a host of real estate investments within one vehicle, this meant investors could avoid involvement with the management or financing of the real estate holdings themselves.
In a traditional REIT, investors buy shares in the REIT company, which will typically own a collection of real-estate properties. In an UPREIT, however, instead of buying shares outright, property owners may trade their property for units – usually of an equivalent value – of the REIT.
In an UPREIT exchange, the REIT company offers the property owner ‘units’ in exchange for their property, which can be traded for shares in the REIT. Alternatively, investors can simply hold the shares – for a minimum period of a year – before trading the units in for their cash value. It should be noted, however, that capital gains taxes on UPREIT are only payable when you sell your units. This lets owners manage their tax liability by selling shares over time, or they can hold indefinitely, without having to pay taxes.
What are the benefits of an UPREIT?
There are numerous reasons why UPREITs have become popular with property owners and investors in recent years. Here are just five major reasons why:
1. Easier Exchange Process. Much of the anxiety investors face in the 1031 exchange process is the task of identifying a like property to transfer equity into within the required timeframe. Often this leads to overpaying for subpar deals just to hit the strict 1031 timeline. With unpredictable real estate markets, changing interest rates, & buyer competition, a 721 Exchange takes the guess work out of the transaction.
2. Greater diversification benefits. Trading all your equity into one deal means you'll be taking on sizable individual property risk (market, weather, etc.). An UPREIT investment will be diversified into a large portfolio across a large number of properties and markets.
3. Provides more liquidity than owning a property outright. Another major benefit of exchanging your property for units in an UPREIT is that shares of the UPREIT can easily be bought and sold, allowing investors to retrieve their capital whenever they need to from their investment. Just like any other investment on the stock market, this provides a huge amount of liquidity, especially when compared to buying and selling a physical property – a process that takes a significant amount of time, with months being able to pass before the investor sees their capital again. For this reason, UPREITs offers unique benefits when estate planning, as UPREIT shares can be easily sold by beneficiaries. Likewise, physical properties can be difficult to split between beneficiaries – not to mention burden the beneficiaries with the administration involved in selling the property – whereas shares in an UPREIT are a much easier investment to split between multiple entities.
4. Potential to earn dividends. As UPREITs are comprised of income-generating properties, shareholders can earn income as dividends based on the amount of profit the properties generate. These profits are split proportionally depending on the value of units owned – or the value of the property exchanged into the UPREIT – by the shareholder.
5. Deferred taxation. As already discussed, one of the principal reasons a property owner is likely to carry out a 721 exchange of their property, in exchange for shares in an UPREIT, is because of the tax benefits. Upon sale of a property, a property owner can lose over 20% of the value of the property to tax deductions, while a 721 exchange allows the full value to be reinvested into an UPREIT. Likewise, when estate planning, an UPREIT also comes with tax benefits for beneficiaries, as with any sort of trust, allowing beneficiaries to avoid paying capital gains taxes.
What criteria need to be met to qualify a 721 exchange?
In order for a property owner to exchange their property into an UPREIT, the property must meet the investment criteria set out by the REIT. However, it’s not common for property owners to have the exact type of property that an UPREIT would take on in exchange for units or shares in the UPREIT. To get around this, a 721 exchange is often combined with the framework of a 1031 exchange.
How is a 1031 exchange used in combination with the 721/UPREIT?
Just like the pure like-kind exchange, most properties won’t meet all the criteria set out by the UPREIT, in order for that property to be directly exchanged into the UPREIT. So, like in a 1031 exchange, the property owner sells the original property, then directly contributes the sale value into the UPREIT in exchange for fractional ownership of the collection of real estate properties, which is typically equivalent to the value of the property sold. This is in contrast to the traditional 1031 exchange, where the value is used to buy a replacement property. After a holding period, this fractional ownership – or fractional interest – can be converted into shares which can be sold by the investor if desired.
What is the difference between a DST 1031 exchange and UPREIT?
When selling an investment property and deciding how to reinvest the capital, a DST 1031 exchange and an UPREIT present similar benefits and so are often discussed in tandem. Like an UPREIT, a DST 1031 exchange involves the exchange of an investment property for one or more sections of real estate, such as part of an apartment building or a fraction of a hotel. Similarly, a DST 1031 exchange can provide dividends to investors, while helping them to avoid the stressful timeline of the traditional 1031, in which a property owner must identify a replacement property within 45 days to qualify as 1031 and receive the associated tax benefits.
Evergreen's UPREIT – 721 exchange provides its clients with guidance required to navigate the process. Please contact us for more information (green button below).