How Does a 721 Exchange Work Compared to a Deferred Sales Trust?

Are you interested in selling a piece of real estate and reinvesting the proceeds into other opportunities? You should be aware of the tax implications of the sale and how it could affect the capital available for reinvestment. Several strategies may help manage these tax consequences, including 721 exchanges and deferred sales trusts (DSTs). At 453 Trust Powered by Pennington Law, our experienced trust attorneys can explain the major differences between these two strategies so you can determine which might be right for you. 

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How Does a 721 Exchange Work to Defer Capital Gains Taxes?

A 721 exchange, typically used in a UPREIT structure, allows an owner of commercial or investment real estate to defer capital gains taxes under IRC §721 by contributing the property to a real estate investment trust (REIT) in exchange for partnership units, provided IRS requirements are met.

In a 721 exchange, the property owner contributes their real estate to the operating partnership of a REIT in return for OP (operating partnership) units. The operating partnership becomes the owner of the property, while the former owner becomes a limited partner. In a properly structured 721 exchange, the former owner can defer capital gains taxes and receive a carryover basis in their OP units that reflects the basis of the property contributed. The former owner may also have the right to convert their OP units into REIT shares at a later date.

Key Benefits of Using a 721 Exchange for Real Estate Investors

The primary benefits of 721 exchanges for managing real estate investments include:

• Deferring capital gains taxes: A property owner can reinvest the wealth stored in their commercial or investment real estate into a REIT through a 721 exchange while deferring the capital gains taxes that would accrue if the owner sold their property to another party for cash. 
• Obtaining a passive income stream: REIT shares can provide investors with a passive income stream through the profit distributions that REITs are required to make. The REIT’s managers handle the day-to-day management and maintenance of the properties owned by the REIT’s operating partnership.
• Diversifying investments: An investor who conveys their real estate to a REIT through a 721 exchange can diversify their portfolio, as REITs own multiple kinds of properties in locations across the country. Thus, a property owner can transfer their wealth from a single asset to an entity that owns diverse properties. 
• Estate planning flexibility: Investors who wish to pass their real estate wealth to loved ones may benefit from a 721 exchange, which converts the real estate into shares in a REIT. These shares are easier to divide among heirs than direct ownership in one or more properties. 

Why Understanding 721 Exchanges and Deferred Sales Trusts Matters

When you understand your legal options for deferring or mitigating taxes on liquidating real estate holdings, you can potentially maximize the money you have to reinvest in other opportunities, such as REIT shares or other investments. However, there is no one-size-fits-all solution. Learning how 721 exchanges and deferred sales trusts operate can help you decide which strategy carries the potential for maximum wealth growth and/or provides an income source during your retirement or the next stage of your life. This includes learning how market fluctuations, compliance issues, and IRS approval can impact which strategy you choose. 

Who Qualifies for a 721 Exchange?

Any owner of eligible real estate may qualify to participate in a 721 exchange, including individuals and legal entities such as corporations, LLCs, or partnerships. Eligible real estate includes any property held for business or investment purposes, such as farmland, commercial real estate, or apartment buildings. 

Why You Should Consult a Tax Planning and Trust Attorney Before Using a 721 Exchange or DST

Both 721 exchanges and deferred sales trusts have complex rules and requirements that must be followed to function and remain compliant with IRS regulations. Missteps can cause a deferred sales trust (DST) or 721 exchange to fail, potentially exposing you to unexpected tax liabilities, including possible interest and penalties. As a result, you should make sure you understand the tax implications of using a 721 exchange or a DST before attempting to establish one. An experienced attorney can review your situation to determine how transferring property through a DST or 721 exchange will affect your tax situation and calculate any taxes you may owe in the future. 

Main Differences Between a 721 Exchange and a Deferred Sales Trust

A deferred sales trust, or 453 trust, is another IRS-compliant tool that allows real estate holders to defer capital gains from the sale of a property. However, DSTs offer investors benefits that 721 exchanges do not. So, if you’re asking yourself, “Should I use a DST or 721 exchange for real estate?”, here are the differences between the two:  

• Flexibility in investment opportunities: A 453 trust allows the reinvestment of wealth stored in real estate into various investment opportunities, including real estate, stocks, and other financial assets. Conversely, a 721 exchange reinvests wealth stored in real estate into shares in a REIT. 
• Financial benefits: A deferred sales trust can provide an investor with an income stream according to the installment agreement outlined in the trust documents, which governs payments of principal and income from the sale proceeds. By contrast, a 721 exchange results in the investor receiving REIT shares, which may entitle them to regular distributions from the REIT, subject to its income and distribution policies.
• Tax deferral: Principal payments from a deferred sales trust are generally subject to capital gains taxes in the year they are distributed, based on the allocation in the installment agreement. In contrast, distributions from a REIT received after a 721 exchange may trigger tax recognition events, which could include ordinary income, capital gains, or return of capital, depending on the REIT’s earnings and structure.

Contact Us Today to Understand How a 721 Exchange or DST Protects Your Investments

Have questions about whether a 721 exchange or a DST might be right for you? At 453 Trust Powered by Pennington Law, our nationally recognized attorneys can provide a comprehensive assessment of your situation in a free consultation. Our firm includes professionals from highly regulated legal, financial, and tax industries — all of whom focus on helping clients choose strategies aimed at maximizing wealth growth and advancing their long-term goals.