Updated: Oct 14, 2018
The Perfect Opportunity.. so I thought
I am working with a retired couple who is selling a portfolio of apartment buildings. Their primary objective in this transaction is to defer their taxes. They have owned the properties for 30 to 40 years and they are fully depreciated. Most investors would say this sounds like the perfect opportunity for seller carry-back or owner financing. But wait just a minute. There is an alternative method available to these owners..... the 721 exchange.
How it works
You have probably heard of the 1031 exchange which allows a seller to take proceeds from the sale of a property and invest in a different property without paying capital gains or depreciation recapture tax. The 1031 exchange is a critical component to growing any real estate portfolio. The 721 exchange, also know as an Umbrella Partnership Real Estate Investment Trust (UPREIT), is similar to a 1031 exchange but instead of contributing funds from the sale of a property to a new property, you exchange the property itself for shares in a Real Estate Investment Trust (REIT).
The Final Exchange
Once your property is converted into REIT shares, that is the end of the line for tax deferral. There is no vehicle for exchanging those shares back into real property without paying taxes on your gains first. This is why the 721 exchange is popular for retiring investors who don't intend to purchase any more property.
1031 / 721 Combination
It is possible to combine the 1031 and 721 exchange so that the REIT does not take ownership of the property being sold. With this method, the property is sold to anyone and, using the 1031 exchange, the proceeds purchase a Tenants-in-Common (TIC) interest in a property the REIT is interested in. After an indeterminate amount of time (the IRS has not ruled on this), the TIC interests are converted to REIT shares using the 721 exchange. The REIT commonly orchestrates this entire process for the investor.
Owning shares of a REIT can be convenient compared to owning a property or debt on a property. The owner no longer needs to worry about the property and they receive regular dividends as long as the REIT is performing well. The additional liquidity makes it easy to withdraw funds as needed, although they will incur redemption fees and have taxes to pay. If you'd like to learn more I encourage you to visit www.1031gateway.com and read their article on the subject.
Keep your powder dry.