721 Exchange vs. 1031 Exchange in Minneapolis: Which One Fits a Tired Landlord?

I have a conversation about once a week that goes like this.

An owner in Edina or Bloomington or Woodbury bought a building twenty-some years ago. It is worth $4 million now. He paid $1.2 million, he has depreciated most of it, and he is tired. The roof is due, a tenant is behind, and his lender wants a new appraisal before the renewal.

He knows he should sell. He also knows what happens when he does.

Here is what I tell him, and it is the same thing I would tell you.

First, the bill if you just sell

Let's use round numbers. $4 million sale, $1.2 million purchase price, $900,000 of depreciation taken, so an adjusted basis around $300,000. Call it a $3.7 million gain after closing costs.

• Depreciation recapture on the $900,000 at 25% federal: $225,000.
• Federal capital gains on the remaining $2.8 million at 20%: $560,000.
• Net investment income tax at 3.8% on the whole gain: about $140,000.
• Minnesota income tax. Minnesota has no capital gains rate. Gains are ordinary income, up to 9.85%, plus a 1% surtax on investment income over $1 million. Call it $350,000.

That is roughly $1.3 million to the government on a $4 million building. A third of the check. Your CPA will get a different number depending on your bracket and your state of residence, but it will not be a small number. Tax rates and laws change, so please run this with your advisors.

Nobody likes writing that check. So most owners do one of two things instead.

Option one: the 1031 exchange

You sell the building, a qualified intermediary holds the money, and within 45 days you identify another property. Within 180 days you close on it. If you buy something of equal or greater value and replace the debt, the gain rolls forward. No tax today.

The 1031 is a great tool. I have used it. Here is the part people leave out.

You now own another building. Usually a bigger one, because you had to spend all the proceeds. Often a leveraged one, because you had to replace the debt. And you had 45 days to find it in a market where the good buildings never hit LoopNet. So you bought what was available, not what you wanted.

You traded a tired building you knew for an unfamiliar building you had to buy on a deadline. The tenants, the roof, the lender: all still yours. Just different ones.

If you love owning real estate and you have the energy for another ten-year hold, the 1031 is your answer. Plenty of people do. I wrote a book about it.

If the honest answer is that you are done managing buildings, keep reading.

Option two: the 721 exchange

Section 721 of the tax code says that when you contribute property to a partnership in exchange for an interest in that partnership, it is not a taxable sale. That is the same rule that lets two people form an LLC and put a building into it without paying tax. The big REITs use it constantly; they call it an UPREIT.

We use it with AlphaDiv Real Estate Fund, our open-end fund that owns 23 properties in the Twin Cities. You contribute the building at appraised value. We pay off or assume the debt. Your net equity converts to Series A Units at the current unit price. You walk away with units, quarterly distributions and a K-1, and we walk away with the roof, the tenant and the lender.

No 45-day clock. No intermediary. No replacement property to go find. The tax is deferred just like a 1031, subject to the debt-relief rules your CPA will want to look at under Section 752.

We have done it seventeen times since January 2024. $15.2 million of owner equity, twelve owners, all in the metro.

The honest trade-offs

I am not going to sell you a 721 without telling you what it costs, because the owners who are happiest afterward are the ones who understood it going in.

You give up control. You are a member of the fund. I am the Managing Member. You do not decide when we sell the building you contributed, and you might not like every decision we make.

You give up the next 1031. Partnership units are not like-kind property. The 721 is the last exchange. After that, the plan is hold, collect distributions, and pass the units to your heirs, who under current law get a stepped-up basis. For most of the owners I talk to, that is exactly the plan. For a 45-year-old who wants to trade up three more times, it is the wrong tool.

You give up easy liquidity. You can request a redemption, but it is at my discretion, subject to a holding-period multiplier, and it is generally a taxable event. If you need the cash in two years, sell the building or do a 1031.

The decision, in one question

Do you want to own a building for the next ten years, or do you want income from real estate for the next twenty?

If it is the building: 1031. Call a qualified intermediary before you list, not after. We will happily buy your building on your exchange timeline, and we might have a replacement property you want.

If it is the income: 721. Send me the address. Within three business days you will have a written contribution offer with the value, the debt treatment, the unit count and the expected distribution, and your CPA can pick it apart.

And if you want to keep the building and keep managing it, that is a fine answer too. Just fix the roof before the lender makes you.

Mike Sowers, CCIM founded Commercial Investors Group in 2005 and is the Managing Member of AlphaDiv Real Estate Fund. He is the author of the Amazon bestseller Commercial Real Estate Investing and host of the CREative Commercial Real Estate Show. mike@cre-fund.com