1031 Exchange vs. 721 Exchange: What Real Estate Investors Need to Know
As a real estate investor, it's important to understand the nuances and benefits of different investment exchange mechanisms, particularly the 1031 and 721 exchanges. While serving the same purpose of deferring capital gains, these two options offer distinct paths and tax advantages in your real property investment journey.
For those looking to continue their active engagement in real estate while deferring taxes, the 1031 exchange, a like-kind exchange mechanism, allows for reinvestment from one property to another. This option keeps you in the driver’s seat, giving you full control over the new property.
On the other hand, the 721 exchange, part of the UPREIT structure, offers a transition from active property management to a more passive investment role. Here, you trade your own real estate property for shares in a REIT, whose primary benefits are diversifying your portfolio and reducing the day-to-day management burdens.
In the following sections, we'll take a closer look into each exchange type, helping you to make informed decisions for your real estate business. We'll explore the specificities of 1031 exchanges, where control and direct investment are key, and contrast this with the 721 exchange, where you exchange direct property ownership for a stake in a varied and diversified investment professionally managed property portfolio.
What is a 1031 exchange?
You’ve probably heard of a 1031 exchange if you're a real estate investor. A 1031 exchange lets you trade one investment property for another while deferring capital gains tax. According to the Internal Revenue Code (IRC) Section 1031, you must find a "like-kind" replacement asset for it to qualify for a 1031 exchange.
A 1031 exchange allows you to continue growing your real estate investment without paying expensive taxes. However, note that capital gain from this exchange isn't tax-free — it's tax-deferred. You'll eventually have to pay taxes when you sell your replacement property unless, you pass away — in that case, your heirs won't have to pay a capital gains tax either.
The definition of "like-kind" by the IRS is a bit more inclusive than it appears. You could trade a single-family property for units in an apartment building, raw land for a multi-family property, or even shares in specific funds.
The downside: 1031 exchanges can be complex. You have to find the right like-kind property with the right value and nail the IRS’s rigid timeframes. You only have 45 days from the sale of your property to identify a replacement property (you must describe the specific property in detail and provide a written signature) — and you must close on the new property within 180 days to qualify for a 1031 exchange.
What is a 721 exchange?
A 721 exchange is a mechanism long used by institutional investors, but many individual investors haven’t heard of it. If you find a trust or portfolio (known as a Real Estate Investment Trust or REIT) that would be interested in buying your property, instead of swapping your investment property for another tangible real estate asset, you trade a single asset for shares in an investment trust.
Your shares can earn you a steady income and upside potential, and you transition from an active investor to a passive one. With a 721 exchange, you can ditch the hassles of traditional rental property ownership and management (e.g., managing tenants, maintenance, rent collection property taxes, and the like).
Like a 1031 exchange, your 721 exchange doesn't trigger a taxable event. You won't have to pay taxes on your exchange until you redeem your shares. You could do this all at once or spread it out over time during more favorable conditions, like when your tax bracket is lower.
A 721 exchange also gets you shares in a diversified portfolio. Instead of owning a single piece of real estate, you now own shares in a portfolio that may include many different property types and geographic locations — which helps protect your investment from unpredictable market changes.
1031 vs 721 exchange: Key differences
Not sure which exchange is right for you? Here are a few of the key differences to consider:
- Ownership: When you trade your property in a 721 exchange, you don't own that real estate anymore — you own shares in a trust or partnership with 100% control over the property. That means you don't get to decide who lives there or the rent price. But when you 1031 exchange property, you're in full control over all the decision-making since you're the absolute, direct owner.
- Responsibility: With ownership comes responsibility. If you can't find tenants for your property, you'll eat the vacancy costs. If a repair needs to be made, it's coming from your wallet. When you transfer your property with a 721 exchange, you no longer have to worry about maintenance and property management burdens like you do if you use a 1031 exchange and remain the active owner.
- Diversification: A 1031 exchange can help diversify your portfolio if you own other real estate types. A 721 exchange, however, offers even more opportunities for diversification by giving you instant access to an extensive portfolio of different property types and locations.
- Income: Owning your own investment property can net you regular rental income, as can distributions from your REIT shares. Either way, you'll likely make monthly or quarterly income from your investment. However, with a 721 exchange, you'll immediately begin earning passive income. Rain or shine, work or vacation, you'll receive distributions — unlike in a 1031 exchange, when, as the property owner you are responsible for finding tenants, minimizing vacancies, and tracking down rent payments.
Not every property qualifies for a 721 exchange — but all properties can be used in a 1031 exchange as long as you meet the IRS’s criteria and can find a trust to buy your property. When 721 isn’t an option, the owner can 1031 equity into a Delaware Statutory Trust (DST), which qualifies as an "asset in kind." Then, after two years, you can use a 721 exchange to swap the DST interest for shares in a real estate investment portfolio.
Can an investor perform a 1031 exchange after a 721 exchange?
When considering the sequence of tax-deferred exchanges in real estate investment, a critical question arises: Can an investor engage in a 1031 exchange after completing a 721 exchange? The answer, in most cases, is no. The reason lies in the fundamental difference between these two types of exchanges.
A 721 exchange involves converting direct real estate holdings into shares of a Real Estate Investment Trust (REIT), effectively changing the nature of the investment from tangible property to equity. In contrast, a 1031 exchange is designed to exchange like-kind real estate properties. Equity shares in a REIT resulting from a 721 exchange do not meet the 'like-kind' property criteria necessary for a 1031 exchange.
Therefore, once an investor opts for a 721 exchange, the path to immediately transitioning those REIT shares into another direct real estate investment through a 1031 exchange is not typically viable due to these distinct structural differences
Long-term planning with 1031 and 721 exchanges
Utilizing 1031 and 721 exchanges in tandem can significantly enhance an investor's long-term strategy, particularly when considering the lifecycle of their investment journey.
- Phased approach to investment lifecycle: Initially, investors might start with a 1031 exchange to grow their real estate portfolio and defer taxes. This phase is typically characterized by active management and reinvestment in various properties to maximize growth and leverage market trends.
- Transitioning to a more passive role: As investors approach retirement or wish to reduce their active management roles, transitioning to a 721 exchange becomes advantageous. By converting their real estate holdings into REIT shares, investors move to a more passive income stream, which is less demanding in management and offers more liquidity.
- Sustainable income stream in retirement: This strategy ensures a steady income through dividends from REITs, which is particularly appealing for retirees. The diversification within REITs also spreads risk across various properties and geographical locations, providing a more stable investment in the face of market fluctuations.
Estate planning considerations
The 1031 and 721 exchanges offer unique tax benefits used in estate planning and investment purposes, with the 721 exchange playing a pivotal role due to its step-up in basis advantages.
- Minimizing tax burden for heirs: One of the most significant benefits of holding REIT shares (acquired through a 721 exchange) is the potential for a step-up in basis upon the investor's death. This means heirs may receive the investment at its current market value, not the original investor's purchase value.
- Avoiding capital gains tax: If the property were transferred directly, heirs might be liable for significant capital gains taxes based on the property's original purchase price. However, with the step-up in basis, this tax burden can be significantly reduced or eliminated as the valuation resets at the time of inheritance.
- Simplifying the inheritance process: Transferring shares of a REIT is typically less complex than transferring real estate holdings. This simplicity can be a relief for heirs who may not be familiar with or interested in managing real estate.
- Providing flexibility for heirs: The liquidity of REIT shares offers heirs more options. They can choose to retain the shares and receive dividend income or sell them and invest elsewhere according to their financial goals and needs.
Ultimately, a strategic blend of 1031 and 721 exchanges can bolster an investor's portfolio during their active years and provide a seamless, tax-efficient transition into retirement and beyond. This approach offers a sustainable income later in life and a streamlined, financially beneficial estate planning solution.
How to choose the right option for your investments
1031 and 721 exchanges help with tax deferrals but will lead you down two very different real estate investing paths. Neither is necessarily better than the other — you just need to know which real estate exchange path you’d like to take before making a decision.
Sometimes, owners can use a 1031 exchange and a 721 exchange together to get the final investment they want.
Not sure which option is right for you? Don't worry — Flock Homes can help.
Flock Homes specializes in 721 exchanges and 1031 DST exchanges. Call us at (720) 703-9992, and we can help you with your options.
Visit flockhomes.com for more information.
1031 vs 721 Exchanges FAQs
What is the difference between a 1031 and 721 exchange?
The primary difference between a 1031 and a 721 exchange lies like the investment and the control over the property. A 1031 Exchange, often referred to as a "like-kind" exchange, is a mechanism that allows investors to defer capital gains taxes by reinvesting the proceeds from the sale of one investment property into another.
This exchange is characterized by direct real estate investment, where the investor controls the property. On the other hand, a 721 Exchange, integral to the UPREIT structure, involves the exchange of real estate for shares in a Real Estate Investment Trust (REIT).
Unlike the 1031 Exchange, the investor does not retain direct control over individual real estate assets. Instead, they receive an interest in a trust that manages a diversified portfolio of properties, marking a shift from active property management to a more passive investment approach.
What are the disadvantages of the 721 exchange?
- Loss of control: By exchanging property for REIT shares, investors give up direct control over the specific real estate assets.
- Market risks of REITs: REITs are subject to market fluctuations and specific risks associated with the trust's property portfolio.
- Less flexibility in property choices: Investors are limited to the properties held within the REIT, which may not always align with their preferences.
- Complexity and eligibility: Not all properties may qualify for a 721 exchange, and understanding the nuances of REITs can be complex.
What is Section 721 of the exchange Code?
This section governs the 721 exchange. It allows investors to contribute property to a partnership (like a REIT) in exchange for partnership interests (or shares) without recognizing capital gains at fair market value at the time of the exchange. The intent is to facilitate larger real estate investments and diversification, moving from active management to a more passive investment strategy.