IRC Section 721 Exchange Two Roads to Travel

There are a few alter­na­tives investors use to defer the pay­ment of cap­i­tal Gains. IRC §721 may be one of the alter­na­tives to research for your needs.  Investors may arrive at a §721 via trans­fer­ring their prop­er­ty to a Real Estate Invest­ment Trust (REIT) or part­ner­ship.

By Al DiNi­co­la, AIF®, CEPA™
Novem­ber 10, 2023
Adinicola@namcoa.com
DST 1031 Spe­cial­ist
NAMCOA® — Naples Asset Man­age­ment Com­pa­ny®, LLC
Secu­ri­ties offered through MSC-BD

Recent­ly the oth­er method pro­vid­ed to investors is when uti­liz­ing a §1031 tax deferred exchange into Delaware Statu­to­ry Trust (DST) inter­est and then being con­vert­ed into a §721. The con­ver­sion would not hap­pen imme­di­ate­ly for many rea­sons.

What is a Sec­tion 721 Exchange?

A Sec­tion 721 exchange is a pro­vi­sion in the Unit­ed States tax code (IRC Sec­tion 721) that allows investors to defer cap­i­tal gains tax on cer­tain types of prop­er­ty trans­fers. Typ­i­cal­ly, an investor is mov­ing §1031 prop­er­ty into anoth­er invest­ment vehi­cle via §721.   The pri­ma­ry pur­pose of Sec­tion 721 is to pro­mote invest­ment in real estate and part­ner­ships by pro­vid­ing tax incen­tives for those who engage in these trans­ac­tions. IRC descrip­tion reads some­thing like this.  “§721. Non­recog­ni­tion of gain or loss on con­tri­bu­tion: (a) Gen­er­al rule- No gain or loss shall be rec­og­nized to a part­ner­ship or to any of its part­ners in the case of a con­tri­bu­tion of prop­er­ty to the part­ner­ship in exchange for an inter­est in the part­ner­ship.” In many cas­es the investor may be exit­ing a 1031 exchange and seek­ing to con­tin­ue a pas­sive invest­ment and expand their diver­si­fi­ca­tion.

Why move into a REIT?

When you move your real estate sin­gle asset into a REIT (via §721 UPREIT) you are con­vert­ing real estate own­er­ship of a sin­gle prop­er­ty (or asset) into a poten­tial much larg­er pool of assets.  In return you will receive Oper­at­ing Units. The pool of assets may include a vari­ety of real estate assets and diver­si­fi­ca­tion.  

Are you ready to move into a §721?

There is an age old say­ing of “what do you want and why do you want it”. The process may start with the investor attempt­ing to iden­ti­fy which type of invest­ment prop­er­ty they may wish to invest in, in order to defer cap­i­tal gains. Investors may start out with a §1031 and seek alter­na­tives.

Do you have the cor­rect enti­ty?

The enti­ty set up will be the one to receive inter­est in the new ven­ture or part­ner­ship. This needs to com­ply with IRC reg­u­la­tions (i.e. same tax­pay­er, etc.).

Prop­er­ty Con­tributed or Trans­ferred.

The rea­son the investor is enter­ing the §721 is to trans­fer a prop­er­ty that has appre­ci­at­ed in val­ue. This trans­fer of a qual­i­fy­ing asset is a tax deferred event. The trans­fer goes into a REIT part­ner­ship. This has been ref­er­enced as an UPREIT.

OP Units Inter­est

The investor receives OP Units (Oper­at­ing Part­ner­ship Units) when the prop­er­ty is contributed/donated to the part­ner­ship. There is an eval­u­a­tion as to how many OP Units the investor will receive (val­ue). After COVID there were small hotel own­ers who were con­tem­plat­ing con­tribut­ing their hotel (real estate) to a hotel REIT. In return the hotel own­er would receive OP Units in the REIT.  There are safe har­bor rules on any with­drawals or sale of units once the real estate is trans­ferred.

Defer­ral of Tax­es and Poten­tial Growth

Defer­ring tax­es may be the imme­di­ate investor goal by trans­fer­ring their prop­er­ty.  Tax­es are deferred until the investor decides to sell any of the OP units. Many investors would also seek to have some increase in val­u­a­tion or growth of the invest­ment.

Sales of Units cre­ate Tax Con­se­quences- Cap­i­tal gains are deferred until the sale of any OP Units. Each investor may or will have a dif­fer­ent applic­a­ble cap­i­tal gains rate.

Sec­tion 721 Exchanges not for every­one. § 721 exchanges may not be a solu­tion for every­one despite their ben­e­fits there are always draw­backs. Younger investor may pre­fer the §1031 route per­mit­ting mul­ti­ple exchanged over the course of many years. There are many who may poten­tial­ly ben­e­fit.

The group may include real estate investors and cur­rent part­ner­ship investors. Investors with long term out­looks with an eye to estate plan­ning.

§721 pro­vides real estate investors seek­ing to move from a real estate prop­er­ty and look­ing to con­vert to anoth­er type of own­er­ship. Investors will defer cap­i­tal gains and gain poten­tial liq­uid­i­ty. Part­ner­ships are one of the groups as well as LLCs who can uti­lize §721. The defer­ral of tax­es is per­mit­ted when the investor has appre­ci­at­ed assets con­tributed to the part­ner­ship and receiv­ing OP Units in exchange.

The real ben­e­fit may be with investors who can play the long game, i.e. longer-term invest­ing may ben­e­fit the most. The longer time peri­od may pro­vide for greater growth while main­tain­ing the defer­ral of cap­i­tal gains. The REIT may enable the investor to “peel off” units from their OP Units when the investor needs cash. This is a tax­able event.

The real ben­e­fit in estate plan­ning will be real­ized by the heirs.  Estate plan­ning may include assets that ben­e­fit from a “step up in basis”. When there is a  “step up in basis” there would be no cap­i­tal gains or recap­ture of depre­ci­a­tion paid.

Tak­ing a dif­fer­ent approach

Over the past few years spon­sors of Delaware Statu­to­ry trust (DSTs) have start­ed to include §721 as a poten­tial exit strat­e­gy. The Pri­vate Place­ment Mem­o­ran­dums (PPM) will out­line the exit strate­gies pro­vid­ed to the DST investor upon the sale of the DST. The sales will be con­trolled by the spon­sor. The sale of the DST may be ref­er­enced as a full cycle event. The investor may have four options: receive cash upon the sale; com­plete a 1031 into anoth­er DST, com­plete a 1031 into a tra­di­tion­al real estate hold­ing; or con­vert to a §721 via UPREIT. Cer­tain DST have manda­to­ry §721 UPREIT con­ver­sions.   

Upside and Down­side Cau­tion

May advi­sors and CPAs will agree there may be sig­nif­i­cant ben­e­fits cer­tain investors.  There are always con­sid­er­a­tion to be aware and ful­ly under­stand.

• End of the Exchange with §721. Investors may have exe­cut­ed a §1031 in the past. Once an investor has moved their prop­er­ty into a §721 the investor can­not return to a §1031.
• Due Dili­gence should be done to min­i­mize risk. Every investor has a dif­fer­ent risk pro­file.  All invest­ments have risk, and all investors should be aware of the risk of part­ner­ship risk with receipt of OP Units.
• IRS Reg­u­la­tions need to be fol­lowed. Like the §1031 require­ments the §721 rules and reg­u­la­tions need to be fol­lowed. The last thing an investor wants to real­ize is the §721 is null and void.
• Advi­sor Assis­tance may pro­vide addi­tion­al insight. All exchanges may be dif­fi­cult and §721 exchange is no dif­fer­ent.

Final Word

Investors and busi­ness own­ers who are seek­ing alter­na­tives to defer­ring cap­i­tal gains tax­es will typ­i­cal­ly review a 1031 exchange.  The §721 pro­vides an alter­na­tive.  §721 require plan­ning and con­sul­ta­tion with your tax con­sul­tant. Always con­sid­er the con­se­quences of mov­ing into a §721 part­ner­ship and the elim­i­na­tion of doing future 1031 exchanges. Investors seek­ing to max­i­mize their tax advan­tages in their real estate hold­ing may con­sid­er 721. Indi­vid­ual investor suit­abil­i­ty is always the focus for any invest­ment.

DSTs are not for all investors.  The acqui­si­tion of a DST is for accred­it­ed investors only.  Con­tact your invest­ment advis­er for addi­tion­al details on how a DST may be a solu­tion to your 1031 Exchange and suit­ed for your invest­ment future. For more infor­ma­tion on how to prop­er­ly set up an IRC 1031Tax Deferred Exchange or if you are an accred­it­ed investor and would like addi­tion­al infor­ma­tion on a DST con­tact Al DiNi­co­la at 239–691-8098 or email adinicola@namcoa.com.

This is not an offer to pur­chase or solic­i­ta­tion to pur­chase any secu­ri­ty, as such be made only through an offer­ing mem­o­ran­dum or prospec­tus.  Invest­ing in secu­ri­ties, real estate, or any invest­ment, whether pub­lic or pri­vate, involves risk, includ­ing but not lim­it­ed to the poten­tial of los­ing some or all of your invest­ment dol­lars when you invest in secu­ri­ties. You should review any planned finan­cial trans­ac­tions that may have tax or legal impli­ca­tions with your per­son­al tax or legal advi­sor.   NAMCOA, LLC is a Reg­is­tered Invest­ment Advi­sor, reg­u­lat­ed by SEC (Secu­ri­ties and Exchange Com­mis­sion). Our cor­po­rate office is locat­ed at 999 Van­der­bilt Beach Road, Suite 200, Naples Flori­da 34108. Secu­ri­ties Offered through MSC-BD, LLC, Mem­ber of FINRA/SIPC. 8215 SW Tualatin- Sher­wood Rd, Suite 200, Tualatin, OR 97062.  MSC-BD, LLC and NAMCOA are inde­pen­dent­ly owned and are not affil­i­at­ed.

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