How a 721 Exchange (UpREIT) Works
A 721 Exchange (UpREIT) can offer increased liquidity, flexibility, and diversification versus traditional investment property ownership, especially when combined with a DST.
A 721 Exchange makes it possible to convert investment property into equity in a Real Estate Investment Trust (REIT). This form of exchange is typically inaccessible to most investors unless combined with a Delaware Statutory Trust (DST). In this deep dive, we’ll explore the mechanics of 721 UpREITs and where they fit in the landscape of real estate investment tools.
How Does a 721 Exchange (UpREIT) Work?
IRC 721 enables real estate investors to defer capital gains taxes on investment properties sold when acquiring shares in a REIT. Just like a 1031 Exchange enables you to defer taxes while acquiring another investment property or DST, a 721 Exchange allows those funds to go into a REIT.
In order to be eligible for a 721 Exchange, an investor typically needs to relinquish institutional-grade commercial real estate. This is because most REITs are only interested in acquiring this grade of property. This requirement put standalone 721s out of reach for most investors, but the good news is that DST properties can also be eligible for this type of exchange.
Pros and Cons of a 721 Exchange (UpREIT)
Along with the passive income, diversification, and access to institutional-grade properties that DSTs provide, adding on a 721 Exchange (UpREIT) may provide additional benefits to certain types of investors. However, along with these benefits comes potential drawbacks which investors should be aware of before considering this option.
Advantages of a 721 Exchange
- Increased Liquidity
- Upon conversion to REIT shares, investors can potentially sell their shares in the open market, offering a higher degree of liquidity than traditional DSTs. The typical DST holding period is between five to ten years, whereas investors in an UpREIT can often access liquidity in as little as two years.
- Increased Diversification
- REITs generally own a diverse portfolio of properties, further diversifying an investor’s holdings beyond what individual DSTs might offer.
Disadvantages of a 721 Exchange
- Loss of Future 1031 Exchange Options
- One of the most important drawbacks to keep in mind when considering a 721 Exchange is that once property equity has been converted to REIT shares, the option to participate in future 1031 Exchanges is lost.
- Complexity
- The process of transitioning from a DST to an UpREIT can be complex, requiring careful tax planning and guidance. Working with a Licensed 1031 Exchange advisor, along with a tax professional, is recommended to help you navigate this process.
- Potential Liquidity Limitations
- While UpREITs generally offer increased liquidity, there may be restrictions or limitations on the sale of shares, especially during market downturns or periods of high redemption requests.
How 1031 Exchanges, DSTs, and UpREITs Fit Together
By integrating 1031 Exchanges, DSTs, and 721 UpREITs, investors can convert their portfolios from active, direct property ownership into ownership of shares in a REIT. Let’s dive into how this process works and then explore the pros and cons of this approach.
From Fee-Simple to More Flexible Structures
Real estate investors typically start with direct, or fee-simple, property ownership. When they opt for a 1031 Exchange, they can defer taxes on capital gains by reinvesting the proceeds into other real estate investments, including DSTs. Exchanging into a DST enables investors to transition from fee-simple ownership to fractional ownership of institutional-grade investment properties.
Transitioning to UpREITs
The institutional-grade properties contained in DSTs are attractive to many REITs, which is why the UpREIT option becomes possible at this stage. Shares in the DST can be exchanged for Operating Partnership (OP) units in an Umbrella Partnership Real Estate Investment Trust (UpREIT), which is the entity that facilitates the 721 Exchange process. These OP units can later be converted into shares in the REIT.
Unpacking the UpREIT Structure
REITs 101
Real Estate Investment Trusts (REITs) are a popular investment vehicle that provides individuals the opportunity to acquire ownership in institutional-grade properties. These trusts were established by Congress in 1960 and have since democratized access to high-quality, large-scale properties, previously accessible only to entities like pension plans and life insurance companies. Typically, these properties range from $30 million to $300 million in value.
A REIT is a trust structure with preferential tax treatment, contingent on meeting specific requirements, including a limitation on assets not directly related to real estate or debt instruments associated with real estate. A key feature of REITs is the requirement for prompt distribution of cash flow to investors, usually within 90 days of earnings.
The structure of REITs allows pooled investments from multiple investors to acquire and manage large properties, distributing rental income back to investors. Unlike a C corporation, REITs have no corporate income tax applied, functioning as pass-through entities. Investors in REITs pay tax at their marginal income tax rate and can also benefit from depreciation.
The Three Primary REIT Types
There are three primary categories of REITs:
- Publicly Traded REITs: These are listed on stock exchanges like the New York Stock Exchange and are known for their liquidity and market-driven pricing. However, they can be volatile, as witnessed during the COVID-19 pandemic when REIT indices fell significantly in a short period.
- Private REITs: These usually have a defined investment duration and are characterized by a lack of redemption requests, providing the sponsor flexibility in managing the assets over the investment term.
- Public Non-Traded REITs: These offer a perpetual life structure with active property management, and share prices are typically set based on a net asset value determined through an appraisal methodology.
REITs offer several benefits, including diversification, potential for continuous income, and preferential tax treatment. However, they also come with considerations like relinquishing management control, potential changes in tax laws, and limitations on liquidity under certain market conditions.
A unique feature of REITs is the 721 UpREIT transaction, which allows tax deferral when an entity absorbs an asset in exchange for ownership. However, direct 1031 Exchanges into REITs are typically not permitted, but one can indirectly participate through a Delaware Statutory Trust (DST) that engages in a 721 UpREIT transaction.
The 'Umbrella Partnership REIT' Model
In an UpREIT, also known as a Section 721 (c) partnership, investors contribute their properties to a partnership that is part of the REIT in exchange for Operating Partnership (OP) units. This conversion allows for continued tax deferral and the possibility of later converting these OP units into shares of the REIT itself.
Hardwired vs. Hybrid UpREITs
UpREITs come in two versions: hardwired and hybrid:
- Hardwired UpREITs: In this structure, a typical holding period for the Delaware Statutory Trust (DST) is around two years, after which all investors who have exchanged into the DST are mandatorily included in the UpREIT transaction. This means that upon the end of the hold period, their investment in the DST is converted into ownership in the REIT. This structure is more rigid, offering less flexibility to investors but providing a straightforward path to REIT participation. The decision to participate in a Hardwired UpREIT is made at the time of investing in the DST, and once in the REIT, investors cannot perform another 1031 Exchange.
- Hybrid UpREITs: The Hybrid UpREIT structure is more flexible, with an average hold period ranging from three to five years. This structure allows investors to defer the UpREIT decision, providing an opportunity to perform another exchange or to opt into the REIT at a later stage.
721 UpREIT Example
Elizabeth, who had successfully managed her direct property investments over the years, sought a more efficient method for transferring her estate to her beneficiaries. Her objective was to transition into a Real Estate Investment Trust (REIT) without enduring the tax liabilities associated with outright property sales. Her strategic approach involved utilizing a Delaware Statutory Trust (DST) as an intermediary. By engaging in a 1031 Exchange, Elizabeth transferred her properties into the DST, effectively deferring taxes and embracing the realm of passive investment.
The DST played a critical role in Elizabeth’s broader strategy, which ultimately led to an UpREIT. Upon the DST’s integration into the REIT, Elizabeth received Operating Partnership (OP) units. This maneuver allowed her to benefit from the diversified nature of a REIT while maintaining advantageous tax conditions.
Elizabeth’s foresight yielded significant benefits. Upon her passing, her heirs inherited the OP units, now valued at a stepped-up basis, which substantially reduced their capital gains tax obligations. In this case, her heirs had the option to sell these units in just two years, accessing liquidity sooner than would be possible in a traditional DST. This inheritance provided them with the benefits of REIT investment minus the direct challenges of property management, thus fulfilling Elizabeth’s vision for a streamlined legacy transition through her astute use of a DST and UpREIT.
UpREIT FAQs
A 721 UpREIT facilitates the contribution of property into a REIT in exchange for OP units, with a tax-deferral mechanism akin to a 1031 Exchange. However, it differs from the 1031 Exchange in its allowance for a transition into diversified REIT investments, rather than requiring like-kind property exchanges.
721 UpREIT investments are designed for accredited investors who meet specific financial criteria, ensuring they have the requisite financial acumen and resources to understand and bear the risks of such investments.
Accredited investors are individuals with a net worth exceeding $1 million, excluding the value of their primary residence, or those with an annual income over $200,000 (or $300,000 for joint income) for the last two years with the expectation of earning the same or higher income in the current year.
Exiting an UpREIT involves converting OP units into REIT shares, which can be sold on the open market. However, this conversion and subsequent sale may trigger tax implications that should be carefully considered.
The primary tax benefit of a 721 UpREIT transaction is the deferral of capital gains tax on the exchange of real estate for OP units. However, eventual conversion of these units to REIT shares or other dispositions may result in tax liabilities.
721 UpREIT opportunities are typically offered through companies specializing in real estate investments, financial advisors, or firms that provide comprehensive estate and tax planning services. The Licensed 1031 Exchange Advisors at Real Estate Transition Solutions can connect you with UpREIT opportunities that align with your goals.
Speak with a Licensed Exchange Advisor
Navigating the complexities of 1031 Exchanges, DSTs, and UpREITs requires expert guidance. If you’re a real estate investor with questions about 721 Exchanges, DSTs, or estate planning, contact Real Estate Transition Solutions to schedule a complimentary consultation with one of our licensed 1031 Exchange Advisors.
Our free consultations can be done over the phone, via web meeting, or in person at our offices located in Seattle, WA and throughout the West Coast. To schedule your free consultation, call 888-755-8595, email info@re-transition.com, or book directly with an Advisor online.
About Real Estate Transition Solutions
Real Estate Transition Solutions (RETS) is a consulting firm specializing in tax-deferred 1031 Exchange strategies and Delaware Statutory Trust investment property. For over 26 years, we have helped investment property owners perform successful 1031 Exchanges by developing and implementing well-planned, tax-efficient transition plans carefully designed to meet their objectives. Our team of licensed 1031 Exchange Advisors will guide you through the entire process, including help selecting and acquiring passive management replacement properties best suited to meet your objectives. To learn more about 1031 Exchanges and Real Estate Transition Solutions, visit re-transition.com or call us at 888-755-8595.
