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An Introduction to 721 Exchanges

The 721 exchange, akin to the 1031 exchange, presents an avenue for investors to postpone capital gains taxes while relinquishing control of a property used for business or investment purposes. These tax deferral methods offer investors alternatives to traditional sales, where taxes can amount to over 20% of capital gains.

How does a 721 exchange function?

In a 721 exchange, also known as an "UPREIT," an investor transfers property to a REIT in exchange for units in an operating partnership, which are later converted into shares of the REIT.

What are the primary benefits of a 721 exchange?

  1. Passive Income: REIT shareholders enjoy passive income as managers oversee the REIT's operations and assets, relieving investors of day-to-day decision-making responsibilities.

  2. Tax Advantages: Through a 721 exchange, gains from property sales are deferred, unlike in typical sales where gains are subject to immediate taxation. This allows investors to utilize 100% of sale gains to purchase REIT shares without facing significant tax burdens.

  3. Diversification: Investing in REIT shares through a 721 exchange offers diversification benefits, with properties spread across various geographic locations, tenant profiles, industries, and asset classes.

  4. Estate Planning: The 721 exchange is a beneficial strategy for estate planning, as it simplifies asset transfer to heirs through shares held in a trust, enabling them to avoid capital gains and depreciation recapture taxes upon inheritance.

Can an investor combine a 1031 exchange with a 721 exchange?

Combining a 1031 exchange with a 721 exchange allows investors to acquire fractional interests in institutional-grade properties that meet REIT criteria, maintaining the 1031 exchange status. After holding the fractional investment for a sufficient period, typically around 24 months, investors can exchange it for REIT shares.

Can an investor perform a 1031 exchange after a 721 exchange?

Once a 721 exchange is completed, capital gains taxes cannot be deferred further through a 1031 exchange, as REIT shares are ineligible. If REIT shares are sold or capital is returned to investors, capital gains or losses must be recognized upon tax filing.

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