If you’re investing in property and looking for ways to defer or mitigate federal capital gains taxes, Section 721 of the Internal Revenue Code offers a solution. Instead of selling your property for cash, the tax rule allows you to exchange it for shares in a real estate investment trust (REIT), which can result in tax deferrals.1 Various types of tangible and intangible property contributions are typically allowed in the trust, including real estate. Any associated liability with a property, such as a mortgage, is assumed by the REIT. While there may be financial benefits to taking advantage of a 721 exchange, it’s also important to consider this type of exchange cautiously and plan for it diligently.
How does a 721 exchange work?
An umbrella partnership real estate investment trust (UPREIT) is a unique type of REIT structure that allows you to exchange real estate for operating partnership (OP) units without immediately triggering federal capital gains taxes, potentially saving you a significant amount of money.2 The OP units you receive in the exchange can later be converted into REIT shares and sold on the public market, thereby deferring taxes until you sell these units or shares. The REIT shares provide liquidity that direct property ownership might not offer. You also gain exposure to a diversified portfolio of real estate assets, reducing the risk associated with owning a single property.
Here’s a hypothetical example of a Section 721 exchange: John owns a commercial property valued at $2 million, which he originally purchased for $1 million. If John sells the property, he will face a significant capital gains tax on the $1 million appreciation. As an alternative, he contributes it to an UPREIT and doesn’t pay capital gains taxes at the time of the exchange for OP units. Over time, John can convert his OP units into REIT common shares and when he sells those shares, he will recognize capital gains at a more manageable tax hit. The REIT shares can provide John more control over meeting his liquidity needs and managing taxes.
Drawbacks of 721 exchanges
With federal tax deferral and diversification advantages, a 721 exchange might appear like the ideal solution for dealing with capital gains, however, there are also several risks to consider:
- Liquidity: The shares you receive in a 721 exchange are not publicly traded, which can limit your ability to quickly convert them to cash. Additionally, there may be restrictions on when and how you can convert OP units into REIT shares.
- Valuation: The value of the property you contribute must be accurately assessed. Overvaluation or undervaluation could impact the number of OP units you receive. The value of REIT shares can also fluctuate based on market conditions, potentially affecting the overall value of your investment.
- Taxes: Keep in mind that you can defer capital gains taxes with a 721 exchange, but you can’t eliminate them. Eventually, taxes will be due when you sell the REIT shares. Also, tax laws change and the tax deferral benefits of the 721 could go away in the future. If you own the shares until death, there could be a step-up in cost basis, allowing beneficiaries to inherit the shares without ever paying capital gains tax.
- Operational: The success of your investment depends on the performance of the REIT’s management team. Poor management can negatively impact returns. Moreover, REITs have operational costs that can affect the overall returns on your investment.
- Regulatory: The REIT must comply with various regulations, including maintaining its status as a REIT. Non-compliance can lead to penalties and affect your investment.
- Market: The value of the REIT’s portfolio is subject to real estate market conditions. Economic downturns or changes in the real estate market can impact the value of your investment. However, REITs are generally less volatile than stocks and have historically outperformed the S&P 500.3
Additional considerations
A 1031 exchange is similar to a 721 exchange for deferring capital gains taxes, except you invest the proceeds from selling your investment property into a like-kind property instead of contributing the property to a REIT and getting shares in return.4 The most common types of like-kind options are real estate but there’s also the option of a Delaware statutory trust (DST). Unlike with a REIT where you’re basically investing in a company, with a DST you’re investing in a property for part ownership. There are complex rules for participating in a 1031 exchange, including taking specific steps with proceeds from your sale, meeting critical deadlines, and tax reporting.
If you unable to find a REIT to directly purchase your property in exchange for OP units, there are several large commercial real estate firms that offer an exchange program. This program involves a 1031 exchange into a property which is held in a DST outside of the REIT, followed by a waiting period of two or more years. The REIT would then have the option to purchase this property via a 721 exchange for OP units. If you have multiple real estate investments or commercial property, it may be worth consulting a tax or financial professional to help navigate these transactions as there’s potential risk of missing a tax rule.
Want to learn more?
This article scratches the surface of 721 and 1031 exchanges for deferring federal capital gains taxes. Due to the complexity of exchanges and potential changes to the tax laws supporting them, proper management can be tricky. Even knowledgeable real estate investors face risks that could significantly impact their portfolios and cash flow. However, preparing ahead and incorporating these strategies into your financial plan can help save you money. If you’re a Mercer Advisors client and haven’t been talking to your wealth advisor about real estate and property tax planning strategies, reach out now.
If you’re not a client and have an interest in deferring federal capital gains taxes on property, we can help. Because your finances work better when they work together, Mercer Advisors offers a comprehensive wealth management solution that integrates investment management along with financial planning, tax planning, estate planning, and insurance solutions. Want to learn more about REITs, UPREITS, 721 exchanges, and 1031 exchanges, or other real estate and tax deferral topics? Let’s talk.
1 “Considering a 721 Exchange? Adopt a Buyer Beware Mindset.” Kiplinger, 11 Sept.2024.
2 “What Is an UPREIT and How Does It Work in Real Estate Investing?” Accounting Insights, 6 Feb. 2025
3 “REITs vs. Stocks: What Does the Data Say?” The Motley Fool, 4 March 2024.
4 “1031 Exchange: Do You Know Your ‘Like-Kind’ Options?” Kiplinger, 24 Aug. 2023.
Mercer Advisors Inc. is a parent company of Mercer Global Advisors Inc. and is not involved with investment services. Mercer Global Advisors Inc. (“Mercer Advisors”) is registered as an investment advisor with the SEC. The firm only transacts business in states where it is properly registered or is excluded or exempted from registration requirements.
All expressions of opinion reflect the judgment of the author as of the date of publication and are subject to change. The information is believed to be accurate but is not guaranteed or warranted by Mercer Advisors. Content, research, tools and stock or option symbols are for educational and illustrative purposes only and do not imply a recommendation or solicitation to buy or sell a particular security or to engage in any particular investment strategy. All investment strategies have the potential for profit or loss. Diversification and asset allocation do not ensure a profit or protect against a loss. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will either be suitable or profitable for a client’s investment portfolio. Hypothetical examples are for illustrative purposes only. For financial planning advice specific to your circumstances, talk to a qualified professional at Mercer Advisors.
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