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Alternative Investments in a 1031 Exchange: 1031 versus 721

Maura Snabes, Esquire, Principal, CES®, NTP®
April 11th, 2024

Taxpayers often look for alternative, passive investments as Replacement Property in a 1031 tax-deferred exchange. One option for taxpayers is to combine a Section 1031 exchange with a 721 exchange.

In a 721 exchange, a Real Estate Investment Trust (REIT) or Umbrella Partnership Real Estate Investment Trust (UPREIT) must be willing to acquire a taxpayer’s Relinquished Property. However, not all properties are of the type that the REIT will accept. In these cases, the combination of a 1031 and 721 exchange may be the ideal option.

The arrangement would generally work as follows: 

1.
The Taxpayer investor (TP) enters into an exchange agreement with a Qualified Intermediary (QI), like Corporate Exchange Services, to facilitate the 1031 Exchange.
2.
TP closes on the disposition of the Relinquished Property, with the QI receiving the proceeds from the sale. 
3.
TP has 45 days to identify the Replacement Property.  TP wants a more passive investment, so identifies a fractional interest in property held in a Delaware Statutory Trust (DST) that meets the criteria of the REIT in which the investor wants to invest.
4.
TP closes on the acquisition of the Replacement Property within 180 days (or the due date of the tax return, including extensions, whichever is earlier). 
5.
TP holds the DST interests for a sufficient amount of time (typically around 24 months) to keep the 1031 exchange intact.
6.
TP then does a 721 exchange by contributing the DST property into an UPREIT structure under Section 721, allowing the taxpayer to ultimately acquire Operating Partnership (OP) Units that are essentially the equivalent to an interest in the REIT itself.
REIT shares themselves are not eligible to be used in a 1031 exchange, and therefore once a 721 exchange is completed, this is the end of the line for deferral of capital gains taxes. If the shares of the REIT are sold, or the REIT sells a portion of the portfolio and returns capital to the investors, the investors will be required to recognize any capital gain or loss when they file their taxes. However, like the stepped-up basis that an heir of a real estate owner receives at the time of the owner’s death, for REIT/UPREIT interests, if the contributing property owner dies, their OP Units receive a step-up in basis to the value at time of death, eliminating any taxes that would be due on that increase in value.
The contents of this are not intended to be and should not in any way be construed to contain legal or tax advice. Any U.S. federal tax advice contained in this communication  is not intended to be used and cannot be used for the purpose of (i) avoiding penalties under the Internal Revenue Code of 1986, as amended; or (ii) promoting, marketing or recommending to any other party any transaction or tax related matters.
MAURA A. SNABES

Esquire, Principal, CES®, NTP®
Ms. Snabes practices in the area of Real Estate and Corporate Law. Maura has been the corporate legal counsel for a title company since 1994. She is a Certified Exchange Specialist as certified by the Federation of Exchange Accommodators.

Conclusion

Combining 1031 and 721 exchanges opens up passive real estate investment opportunities. As your trusted 1031 exchange facilitator, we’re here to guide you through the process. Contact us to discuss how we can help you defer taxes and achieve your investment goals.
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