Deferring Capital Gains Taxes With a 721 Exchange
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.