What is the difference between a 1031 Exchange and a 721 Exchange?

Both a 1031 exchange and a 721 exchange allow Exchangers to defer capital gains and other taxes on the sale of business or investment use real estate when proper procedures are followed, however they do have differences and they cannot be used interchangeably as each has specific considerations.

What is a 1031 exchange?

1031 exchange is one of the most popular tax strategies available when selling and buying real estate “held for productive use in a trade or business or investment”. Property owners of real estate used for business or investment use can utilize a 1031 exchange on the sale of the property to defer capital gains, depreciation recapture, state, and net investment income tax when they reinvest the proceeds from the sale into the purchase of qualifying property. It does not have to be the same kind of property. All types of real estate are considered like kind to all other types.

In a 1031 exchange, the Exchanger is not permitted to receive nor control and is not allowed to “benefit” from the funds from the sale of their sold property, the relinquished property. An example of benefitting would be to pledge the account as collateral for a loan. The funds are held with a Qualified Intermediary until the time the Exchanger is ready to close on the sale of their new property, the Replacement Property. The funds are then directly used to purchase the replacement property. Because the Exchanger never actually had any access or benefit from the funds and since the Exchanger traded the relinquished property for the replacement property through the Qualified Intermediary, they may defer the taxes they would normally pay if they had sold the property outright and retained the money.

What is a 721 exchange?

A 721 exchange, formally referred to as a 721 Umbrella Partnership Real Estate Investment (UpREIT), is similar to a 1031 exchange in that a real estate investor can sell a property used for business or investment use and defer taxes on the sale if they reinvest the funds by following specific criteria.

In a 721 exchange, the investor either (1) transfers ownership of the relinquished property to the REIT and receives an equivalent value in the form of operating partnership units or (2) or sells to a third party of choice using a 1031 exchange and investing the funds into a DST, often made available by the REIT. When sufficient time passes, usually two years, the DST interest can be traded for Real Estate Investment Trust (REIT) shares.

Similarities and Differences of a 1031 Exchange and 721 Exchange

Similarities

There are a handful of similarities between a 1031 exchange and a 721 exchange, which include:

• Property being sold must be held for business or investment use
   
• When properly executed, both defer capital gain tax, depreciation recapture, state and net investment income tax
   
• Both allow for investment diversification
   
• Both allow heirs of the Taxpayer to get a “step-up” in basis if they pass away still vested with the REIT interest or Replacement Property interest in the case of a 1031 exchange

Differences

The differences between a 1031 exchange and a 721 exchange are notable and include:

• A Qualified Intermediary facilitates a 1031 Exchange, while a 721 exchange is facilitated by the REIT sponsor
   
• 721 exchanges do not have the same timelines, 45-day Identification and 180-day Exchange period, as a 1031 Exchange 1031 exchange Replacement Property Identification Rules do not apply to 721 exchanges
   
• In a 721 exchange a REIT must be willing to either acquire your Relinquished Property, or go through the process described above with a 1031 exchange and later trade for the REIT shares.
   
• In a 721 exchange, once an investor sells the property to the REIT, they cannot do another exchange upon sale of the shares held. Once the REIT shares are sold, all the deferred taxes become payable regardless of entering into a new REIT investment. However, under 1031 exchange a Taxpayer can do consecutive exchanges indefinitely to continue deferral.

Both 1031 and 721 exchanges provide real estate investors the opportunity exit out of existing real estate investment and reinvest without tax consequences. However, based on the details above they are unique and advanced planning and a thorough understanding should be in place prior to embarking on either. It is always recommended to talk with your CPA, Tax Advisor, or Financial Advisor prior to implementing any tax deferral strategies.

The material in this blog is presented for informational purposes only. The information presented is not investment, legal, tax or compliance advice. Accruit performs the duties of a Qualified Intermediary, and as such does not offer or sell investments or provide investment, legal, or tax advice.