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SECTION 721 EXCHANGE: DEFER CAPITAL GAINS TAXES WHILE INCREASING DIVERSIFICATION IN REAL ESTATE.
Real estate investors who wish to defer capital gains taxes while increasing diversification in real estate should consider utilizing a section 721 Exchange. Section 721 of the Internal Revenue Code allows an investor to exchange property held for investment or business purposes for shares in a Real Estate Investment Trust (REIT) or an Operating Partnership without triggering a taxable event.

The transaction provides investors with a way of increasing their liquidity and diversification of their real estate investments while deferring very costly capital gains and depreciation recapture taxes that may result from the sale of properties.

Getting To Know Section 721 Exchange
Many tax professionals and real estate investors may be keenly aware of the 1031 Exchange program utilized by REITs as a method of acquiring properties from investors who are interested in selling their real estate investments and must find a replacement property as part of a 1031 exchange otherwise pay hefty capital gains taxes and depreciation recapture taxes. These tax professionals and investors are also most likely aware that most of the time the REITs have many property and investment restrictions, as well as high costs.

Section 721 of the Internal Revenue Code provides investors who are interested in selling their investment real estate to do so without having to find a replacement property. The code also allows real estate investors to capture these tax benefits even if the real estate has already been sold by contributing the funds from the sale of the real estate as they would the property directly into a 721 Operating Company and receiving Operating Partnership Units. 

This transaction is called a 721 Exchange and provides many benefits that will be discussed in this chapter. The Section 721 Exchange has been titled by Real Estate Weekly as “one of Real Estate’s best-kept secrets”. It should be recognized as a popular investment tool for real estate investors who wish to accomplish any of the following or all three - tax-deferral, estate planning, and diversification. It is important to remember that the Internal Revenue Code Section 721 is a complex tax code as is the Section 1031, and therefore all investors should consult their tax and legal professionals before making any investment decision.

WHAT IS SECTION 721 Exchange?
A section 721 Structure allows an investor to exchange property held for investment or business purposes for shares in a REIT or Operating Partnership which can remain in the Operating Partnership or eventually be transferred, tax-free, to a REIT.

Operating Partnerships are formed to aggregate real estate property and proceeds from the sale of real estate property and either retain the assets and/or eventually roll the assets into a REIT if the Partnership so desires.  

This transaction allows investors to increase their liquidity and diversification of their real estate investments while deferring costly capital gains and depreciation recapture taxes that may result from the sale of a property.

The Section 721 exchange is a method to acquire property from investors who are interested in selling their investment real estate but do not want to find a replacement property as part of a 1031 exchange or pay capital gains taxes. Rather than exchanging property for another property, an investor can utilize Section 721 exchange to contribute property/relinquished property monies directly to the Operating Partnership in exchange for Operating Partnership Units. This transaction is often called a “721 Structured Exchange”. Investors seeking to defer capital gains taxes while increasing diversification in real estate should consider utilizing a section 721 Exchange.

THE BENEFITS OF THE SECTION 721 EXCHANGE
In a typical property sale, the seller would pay taxes on the capital gains realized as well as the depreciation that was utilized to defer taxes on the property’s income. The capital gains and depreciation recapture taxes could exceed 20-40% of the gains realized upon the sale, leaving the investor with less capital for reinvestment. A section 721 Exchange allows investors to avoid taxes and keep their wealth working for them in a tax-deferred exchange of their investment property for shares in an Operating Partnership.

The 721 Exchange enables an investor to achieve diversification across geography, industry, tenant, and asset class in an Operating Partnership structure. As a shareholder in the Operating Partnership, the individual investor participates in a diversified portfolio of real estate and is no longer concentrated and dependent on one asset to provide cash flow and appreciation. The Operating Partnership can provide the same ongoing benefits of real estate ownership including income, depreciation tax shelter, principal pay down, and appreciation.

The Operating Partnership can continue to make acquisitions on an ongoing basis. This allows the investor to benefit from future buying opportunities in the Operating Partnership without triggering any capital gains or depreciation recapture tax events.

SPECIFIC INVESTOR BENEFITS
1 Consistent Income: Operating Partnerships can issue dividends or distributions so that the investor has cash flow similar to when they owned their contributed property.

2 Tax Deferral: Contributing property or cash from the sale of real estate into the Operating Partnership provides for a deferral of any taxable income from the sale/transfer of the underlying real estate.

3 Tax Safety on Sale of a Portfolio Asset: On the sale of Operating Partnership property, partnership accounting and management fees generate sufficient expenses to offset any gains investors would be allocated but lockout period provision and indemnification provision normally offset risk of gains.

4 Portfolio Diversification: Investor owns part of an ongoing Operating Partnership with diversified real estate projects.

5 Passive: The section 721 Exchange allows investors to trade an actively managed real estate asset for a portfolio of real estate assets that are actively managed by the principals of an Operating Partnership which focuses operations on real estate development / investment/mortgages. This structure allows individual investors to access and rely upon expertise provided by institutional asset management firms for all decisions regarding the real estate portfolio. The Operating Partnerships are passive investments, structured to provide acquisitions, property management, dispositions, investor communication, and the distribution of investor’s income produced from the portfolio.

6 Estate Planning: The 721 Exchange often is utilized as an estate planning tool to prepare an investor’s real estate assets to be passed down to heirs. When direct real estate assets are passed to heirs, they are often difficult to quickly liquidate and equally divide among heirs. Conflict may arise as to how or when assets are to be sold, and this can create other asset issues for the heirs. The 721 Exchange provides a tailored solution that allows the estate to be prepared for easy transfer while deferring the capital gains taxes that have built up over the years. Before death and the passing down of the estate to heirs, the individual investor continues to receive dividend income. Instead of individual real estate assets, the heirs can receive easily divisible shares in the Operating Partnership that can be much more easily liquidated upon passing of the estate. Heirs who do not want or need funds may continue to hold shares in the Operating Company and receive the dividends. Regardless of the decision of the heirs, heirs receive a step up in basis that permanently removes all capital gains and depreciation recapture taxes deferred in the estate. Beyond the estate planning benefits, the divisibility and liquidity of Operating Partnership shares allow investors to easily sell some of their shares if they are in need of capital.

7 Flexibility: Most often, for an investor to contribute property to a REIT through a UPREIT transaction, the property must meet the REIT’s stringent investment criteria. However, with some well-designed Operating Partnerships, the Operating Partnership can structure the Operating Partnership as it sees fit to entice the most number of like-minded investors.  By utilizing a section 721 Exchange, an individual investor can exchange a property that does not meet the Operating Partnerships criteria for a fractional interest in a high-quality property or portfolio.