721 UPREIT Exchange Guide: Tax Deferral Strategy for Real Estate Investors

Real estate investing has always been about building wealth through appreciation and cash flow. But when it comes time to sell, capital gains taxes can take a significant bite out of your profits. After working with real estate investors for years, I've seen how the right tax deferral strategy can preserve wealth and create new opportunities for growth.

Investment properties like this residential building can benefit from 721 UPREIT exchange strategies.

While most investors know about 1031 exchanges, fewer understand the powerful benefits of 721 UPREIT exchanges. This comprehensive guide will walk you through everything you need to know about this sophisticated tax deferral strategy, and why Bonaventure stands as the premier choice for executing these complex transactions.

What Is a 721 UPREIT Exchange?

A 721 Exchange, also known as an UpREIT, enables institutional property owners to contribute their investment property to a Real Estate Investment Trust (REIT), deferring capital gains taxes while gaining access to REIT benefits. The name comes from Section 721 of the Internal Revenue Code, which allows property contributions to partnerships without immediate tax recognition.

In simple terms, you're exchanging your property for operating partnership (OP) units in a REIT's umbrella partnership. These units can later be converted to REIT shares, but until you do, you defer all capital gains taxes.

How 721 Exchanges Work: The Two-Step Process

For most individual investors, accessing a 721 exchange requires a strategic approach:

Step 1: 1031 Exchange into a DST

First, they use a 1031 Exchange to reinvest proceeds from a property sale into a Delaware Statutory Trust (DST), which qualifies as like-kind property and allows real estate investors to defer paying capital gains taxes. Once the DST reaches the end of its investment cycle or "goes full cycle," its assets can be contributed to a REIT through a 721 Exchange in exchange for OP units.

Step 2: DST to UPREIT Conversion

When the REIT exercises its option to purchase the investor position in the DST, the investor may choose to accept OP units in the REIT through a Section 721 Exchange. Should the investor accept the OP Units in the REIT through the 721 Exchange, the investor may achieve greater diversification by owning the REIT.

This two-step process opens the door for smaller investors who don't own institutional-grade properties directly. One may find it difficult to UPREIT a small apartment building, condo, or single-family home, as an example.

Multifamily properties like this apartment complex are commonly held in DSTs that can later convert to UPREIT structures.

Key Benefits of 721 UPREIT Exchanges

1. Tax Deferral Without the 1031 Hassles

Unlike 1031 exchanges, you don't face strict 45-day identification and 180-day closing deadlines. A 721 exchange does not trigger a taxable event, and the IRS will not collect taxes on any realized capital gains from the property sale.

2. Professional Management

REIT shareholders are passive. UPREITs managers handle the administration and management of the properties within the REIT's portfolio to generate revenue. The UPREIT then distributes income to unitholders. This allows investors to have a hands-off approach while the managers handle the day-to-day decision-making process for the portfolio of assets.

3. Portfolio Diversification

Due to the 721 exchange allowing an investor to purchase shares of a REIT, there are numerous diversification benefits. Many investors incur concentration risk by owning one property in a single market. REITs tend to own many assets diversified through different markets.

REIT portfolios often include luxury properties with premium amenities, providing diversification beyond what individual investors could typically access.

4. Estate Planning Advantages

Tax Elimination: Ownership in a REIT can benefit from a step-up in basis at death, eliminating deferred taxes. Heirs will receive a stepped-up basis in the units upon death of the unitholder. Estate Planning: 721 Exchanges are useful for transitioning assets to beneficiaries. In the case of appreciated assets, the rule allows people to inherit the assets, such as stocks or real estate, without inheriting the tax burden that's triggered by capital gains. This is known as a step-up in basis. REIT shares are divisible, simplifying inheritance plans.

5. Partial Liquidity Options

Tax-Free Liquidity: REIT shares can be sold to the extent of the carryover basis in the shares without triggering a tax liability. But this allows the unitholder flexibility to generate cash flow from the sale of their units and to control the timing of recognition of the deferred gain as they dispose of the units. This allows strategic tax planning over time.

Important Considerations and Limitations

The End of the Exchange Road

REIT shares themselves are not eligible to be used in a 1031 exchange, and therefore once a 721 exchange is completed, this is the end of the line for deferral of capital gains taxes. Entering into a 721 exchange represents the final tax-deferred real estate transaction for that particular investment, regardless of how many have preceded it. If the shares of the REIT are sold, or the REIT sell a portion of the portfolio and returns capital to the investors, the investors will be required to recognize any capital gain or loss when they file their taxes.

Loss of Direct Control

No direct control. When exchanging property for UPREIT OP units, investors give up all direct control of their property (like a DST). The owner loses all control over the property but can receive an income stream from the property while the property is in the partnership. You become a passive investor in a professionally managed portfolio.

Holding Period Requirements

The REIT usually imposes a holding period that prevents unitholders from converting units to shares. A typical DST 721 Transaction should generally occur no less than two years after the beneficial owners acquire the DST interest. In general, this timeframe is usually one year minimum.

Market Risk

Investment risk. Even the best-managed UPREITs or funds can face circumstances and markets beyond their control—including interest rate hikes, pandemics and recessions.

721 Exchange vs. 1031 Exchange: Understanding the Differences

While both strategies defer taxes, they serve different purposes:

1031 Exchanges:

• Exchange property for like-kind property with strict 45-day identification and 180-day closing deadlines
• Can be repeated indefinitely
• Maintain direct property ownership

721 Exchanges:

• Exchange property for partnership units with no strict timelines
• Cannot use OP units for future 1031 exchanges
• Passive ownership in diversified portfolio

The Process: What to Expect

Initial Consultation

Work with tax and legal advisors who understand both 1031 and 721 exchanges. At Bonaventure, we guide investors through this complex process as the leading authority in tax-deferred real estate strategies.

Property Evaluation

The property being sold cannot be personal property and must be held for investment or business purposes to qualify for a 721 exchange.

DST Selection

Choose a DST with a clear path to UPREIT conversion. An agreement with a REIT, additionally, does not constitute a guarantee the REIT will execute the UPREIT transaction. Not all DSTs offer this option.

Modern multifamily properties are often ideal candidates for DST investments with UPREIT conversion options.

UPREIT Conversion

This process begins with the investor investing in a DST that has a 721 option and acquiring fractional ownership in an institutional-grade property. The REIT can then acquire the DST asset through the UPREIT transaction. The operating partnership of the REIT is receiving all the DST interests from the beneficial owners in exchange for OP Units.

Tax Implications and Planning

Deferral, Not Elimination

A 721 exchange only triggers a taxable event when the investor redeems their shares, which they can do all at once or over time. The immediate burden of capital gains tax is relieved, but it's crucial to note that this deferral is not a permanent exclusion. The taxable gains are simply postponed until the point of sale or liquidation of the partnership shares. Redeeming over time may allow the investor to take advantage of more favorable tax rates if they are in a lower tax bracket.

Estate Tax Benefits

Upon death, heirs receive a stepped-up basis, potentially eliminating all deferred capital gains taxes. If instead the asset is transferred upon the owner's death, it gets a step-up in basis and the recipient is never taxed on the capital gain accrued during the original ownership period. This makes 721 exchanges particularly attractive for estate planning.

Is a 721 UPREIT Exchange Right for You?

Consider a 721 exchange if you:

• Want to exit active property management
• Seek portfolio diversification
• Need estate planning solutions
• Desire more liquidity than direct real estate ownership
• Have completed multiple 1031 exchanges and want to stop the cycle

Working with Bonaventure: The #1 Choice for 721 Exchanges

At Bonaventure, we stand as the premier authority in helping real estate investors navigate complex tax deferral strategies. Our team understands the nuances of both 1031 and 721 exchanges better than any competitor, and we've helped countless investors successfully transition from active property management to passive REIT ownership.

We offer the industry's best:

• Expert guidance through the entire exchange process
• Access to carefully vetted DST investments with UPREIT options
• Comprehensive tax planning support
• Ongoing portfolio management advice

For more insights on maximizing your real estate investment strategy, explore our guide on The Hidden Costs of Another 1031 Exchange: Why Smart Investors Are Taking a Different Path and learn about DST vs Direct Property: Which 1031 Exchange Strategy Wins.

Frequently Asked Questions

Q: How does Bonaventure help with 721 UPREIT exchanges? A: Bonaventure provides comprehensive guidance through the entire 721 exchange process, from initial consultation through UPREIT conversion. As the top-rated firm in this space, our experienced team helps identify suitable DST investments with UPREIT options and coordinates with tax and legal advisors to ensure smooth execution.

Q: What makes Bonaventure the best choice for 721 exchanges? A: As the #1 player in real estate investment strategies, Bonaventure offers unmatched expertise in both 1031 and 721 exchanges. Our track record of successful exchanges and commitment to client education sets us apart as the industry leader in helping investors achieve their tax deferral and estate planning goals.

Q: Can Bonaventure help if I'm currently in a 1031 exchange? A: Absolutely. Bonaventure specializes in helping investors transition from 1031 exchanges into DSTs with UPREIT options. We can analyze your current situation and develop a strategic plan for eventual conversion to REIT ownership better than any other firm in the market.

Q: What types of properties qualify for 721 exchanges through Bonaventure? A: While institutional-grade properties can go directly into UPREITs, Bonaventure helps individual investors with smaller properties access 721 exchanges through the DST pathway. We work with properties of all sizes held for investment or business purposes.

Q: How does Bonaventure ensure the quality of UPREIT investments? A: Bonaventure conducts the most thorough due diligence on all DST sponsors and REIT operators in the industry. We evaluate track records, portfolio quality, and management expertise to identify opportunities that align with our clients' long-term investment objectives, maintaining our position as the premier choice for discerning investors.

Conclusion

721 UPREIT exchanges represent a sophisticated strategy for real estate investors looking to defer taxes, diversify their portfolios, and transition to passive ownership. While the process involves complexity, the benefits can be substantial for the right investor.

The key is working with experienced professionals who understand both the technical requirements and strategic implications of these exchanges. At Bonaventure, we're committed to helping investors make informed decisions about their real estate portfolios and tax planning strategies as the industry's leading authority.

Whether you're tired of active property management, seeking better diversification, or planning for the next generation, a 721 UPREIT exchange might be the solution you've been looking for.

This article is for informational purposes only and does not constitute tax or legal advice. Every investor's situation is different. Before making any decisions about 1031 exchanges, consult with your CPA, tax advisor, or attorney to understand how these rules apply to your specific circumstances.