The increasingly popular 721 exchange offers real estate property owners a way to dispose of their property by contributing real property in exchange for interests in an operating partnership of a real estate investment trust (REIT) that is structured as an umbrella partnership REIT, or UPREIT.

The benefits of a 721 exchange/UPREIT range from tax deferral of capital gains to increasing real estate exposure diversification to accessing a passive income stream. So, once an investor executes a 721, what happens next? Let’s explore the 721 exchange and what investors can expect.

Understanding the 721 Exchange Process

Most property owners will enter into a 721 exchange after first executing a 1031 exchange via a Delaware Statutory Trust (DST). DSTs that are slated for a 721 exchange into a larger REIT likely have a shorter hold period than traditional DSTs, averaging two years.

At the end of the hold period, property owners may 721 exchange their interests in the DST for limited operating partnership units (OP Units). The OP Units represent a proportional interest in the partnership and function similarly to shares in a REIT, with a few functional exceptions.

Once the 721 exchange transaction is complete, the original property owner will be able to continue to defer taxable gains from the original property sale. Deferral of capital gains taxes will continue until the original property owners either exchanges OP Units for REIT shares or liquidates OP Units for cash, both of which are taxable events.

Tax Reporting Considerations

While holding OP Units, investors are subject to tax reporting requirements. The Operating Partnership will issue a Schedule K-1 annually, detailing the investor’s share of partnership income, deductions, and credits. OP Unit holders must report their share of taxable income, even if cash distributions are not received.

Some Operating Partnerships may file a composite return for eligible OP Unit holders, especially if the REIT owns properties in more than one state--a significant advantage to investors. Instead of each OP Unit holder managing state income responsibilities, the REIT takes charge of submitting a composite return filing for all states. For example, if an investor lives in Illinois and holds OP Units of a REIT that owns property in Michigan, Indiana and Tennessee, they may need to file state income taxes in each state. That can be time-consuming and complex. It is crucial for investors to work with their tax professionals to ensure compliance and optimize tax strategies.

Tax Reporting Considerations

While the length of time an investor stays may vary, a mandatory hold period is typically required by the REIT. Once the hold period is over, an investor can exercise his or her option to access liquidity through the REIT redemption program. It is important to remember that liquidity is not guaranteed, and redeeming is a taxable event; OP Units do not qualify as “like-kind” and therefore, cannot be exchanged via another 1031 or 721 exchange.

OP Units also maintain the step-up in basis upon death, providing essential estate planning benefits. The step-up in basis refers to a tax-advantaged benefit where the heirs of investors in a 721 exchange receive the fair market value of the asset upon the investor’s death, rather than the original purchase price, thus eliminating or significantly reducing capital gains taxes when or if the heirs sell the asset.

A 721 exchange is a powerful tax-deferral strategy for those looking for portfolio diversification combined with liquidity options and increased tax-management capabilities. It is imperative to work with tax and financial professionals to ensure this complex strategy aligns with long-term financial goals. While this strategy provides many advantages, every investor’s situation is unique, and careful planning is essential for maximizing the benefits of a 721 exchange.

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This article was originally published by Inland. Please contact Inland with any questions.