1031 Exchange vs. 721 Exchange: What Real Estate Investors Need to Know

1031 and 721 exchanges are both excellent real estate investment exchange mechanisms — but they have slight nuances that make big differences in your portfolio.

Want to defer capital gains without managing another real estate property? A 721 exchange might be a good option.

Looking to swap a piece of land for a single-family property you can rent? A 1031 exchange could be your best bet.

Below, we'll break down everything you need to know about 1031 exchanges and 721 exchanges to make the best investment decisions for your real estate business.

What is a 1031 exchange?

If you’re a real estate investor, you’ve probably heard of a 1031 exchange. 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 having to pay expensive taxes. However, note that 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 you have to 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 for shares in an investment trust. Your shares can earn you a steady income and upside potential, and you transition from being 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, 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 exchange 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 that has 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 a 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 out of your wallet. When you transfer your property with a 721 exchange, you no longer have to worry about the burdens of maintenance and property management 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 already own other real estate types. A 721 exchange, however, offers even more opportunity 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, but so 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 begin earning passive income right away. 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. In the case when 721 isn’t an option, the owner can 1031 equity into a Delaware Statutory Trust (DST), which does qualify 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. 

How to choose the right option

1031 and 721 exchanges both help with tax deferrals, but they will lead you down two very different real estate investing paths. Neither is necessarily better than the other — you just need to have a good idea of which path you’d like to take before making a decision.

Sometimes, owners can use a 1031 exchange and 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. Give us a call at (720) 703-9992, and we can help talk you through your options.

Visit flockhomes.com for more information.