A 721 exchange is a powerful tool that offers unique benefits in the world of real estate investment, such as tax deferral, portfolio diversification, and passive income. However, like everything that deals with finance, 721 exchanges are no strangers to complications. If you’re considering performing a 721 exchange to boost your real estate investments, read on to inform yourself of the challenges first.
What Is a 721 Exchange?
First off, let’s get on the same page: what is a 721 exchange? Also known as an UPREIT, this investment method allows real estate investors to defer capital gains taxes by exchanging real property for shares in a real estate investment trust (REIT).
Unlike a 1031 exchange, which involves trading one property for another, the 721 exchange converts property into a diversified portfolio of properties within the REIT.
Though we’re here to discuss the method’s challenges, it’s also important to know its benefits. Here are the main ones:
- Defers capital gains taxes
- Enhances investment liquidity
- Diversifies property portfolio
- Reduces management responsibilities
- Opens access to expert management
- Provides potential for higher returns and passive income
The Challenges of Performing a 721 Exchange
Though the benefits are clearly substantial, performing a 721 exchange presents many challenges. We discuss these below.
Tax Complications
Though a 721 exchange defers immediate tax liabilities, it introduces complex tax implications. Investors must consider potential future tax liabilities, as well as the treatment of depreciation recapture.
Additionally, once you exchange a property for shares in a REIT, the REIT has control over when to sell these properties. If they decide to sell, that results in capital gains for the REIT shareholders that they must pay taxes on.
Valuation Disputes
Determining the accurate value of the property exchanged often leads to disputes. Investors and REITs may have differing valuations, impacting the share quality received in exchange. A 721 exchange advisor can help with property selection to ensure you get the best value for your exchange, but it remains a challenge.
Furthermore, rigorous appraisal processes and negotiations ensure fair value, but they also elongate the timeline for completing the transaction.
Little Control
After exchanging property for REIT shares, investors yield control over property management. This shift can be discomforting, especially if you’re accustomed to hands-on management. The transition requires confidence in the REIT’s management team and its fiduciary responsibilities.
Relinquishing the Property
When performing a 721 exchange, investors part with tangible assets for intangible shares, which can challenge those who view property as a more secure, controllable asset. It also means it’s the end of the line for any property you put in a REIT—you can’t exchange it again or sell it yourself.
Deciding if a 721 Exchange Is Right for You
If deferring capital gains taxes is your only goal, then you should also consider a 1031 exchange. This process lets you reinvest the profits of one property sale into the purchase of a like-kind property. However, there are many more restrictions with this process, and it doesn’t let you diversify your real estate holdings.
If preserving liquidity and diversifying your investments align with your financial goals, a 721 exchange may be worth considering. Discuss your options with your financial advisors to clarify if converting properties into REIT shares supports your long-term objectives.
A 721 exchange is a popular process in real estate investing, and it could be right for you. Now that you understand the challenges of the process, you can make a more informed decision for your situation.