What Is a 721 Exchange (UPREIT) and How Does It Compare?

In the world of real estate investment, finding creative ways to defer taxes and improve portfolio flexibility is a top priority for savvy investors. One strategy that stands out is the 721 Exchange, also known as an UPREIT.

Unlike traditional property sales that trigger capital gains taxes, this method allows investors to contribute appreciated real estate to an operating partnership in exchange for partnership units.

Let’s dive into a detailed exploration of this structure—with plenty of examples, advantages, and even some disadvantages—while comparing it to other tax-deferral strategies like the 1031 Exchange.

What Is a 721 Exchange (UPREIT)?

How Does a 721 Exchange (UPREIT) Work?

A 721 Exchange involves transferring appreciated real estate into an operating partnership that is, in turn, owned by a Real Estate Investment Trust (REIT). In exchange for the contributed property, the investor receives operating partnership units instead of direct REIT shares. These units can later be converted into REIT shares under certain conditions.

Real-World Example:
Imagine a successful real estate developer who owns several prime office buildings in a major city. With market conditions favoring long-term growth and a desire to avoid a hefty tax bill from selling the properties outright, the developer opts for a 721 Exchange.

By contributing these properties to a well-established REIT’s operating partnership, the developer receives partnership units that represent an ownership interest in a diversified portfolio. The developer can later convert these units into REIT shares, enjoying liquidity and potential growth without having to face immediate capital gains taxes.

Advantages of a 721 Exchange with Examples

1. Tax Deferral and Capital Preservation
One of the biggest draws of a 721 Exchange is the deferral of capital gains taxes. Instead of incurring a tax liability upon selling a property, investors can transfer their property to the REIT and receive partnership units.

Example: A family office holding a portfolio of high-value retail centers can avoid an immediate tax hit by executing a 721 Exchange. This deferral not only preserves capital for further investment but also aligns with long-term growth strategies.

2. Diversification Through Professional Management
Investors often have concentrated holdings in a particular property type or region. Converting these holdings into partnership units gives access to a larger, diversified portfolio managed by seasoned professionals.

Example: Consider a regional investor who owns several industrial properties. By converting these assets into UPREIT units, the investor now benefits from the REIT’s diversified holdings—ranging from logistics centers to commercial office spaces—thus mitigating risk through diversification.

3. Enhanced Liquidity Over Time
While the initial partnership units are not as liquid as publicly traded shares, the conversion feature provides a pathway to liquidity. Investors can eventually exchange their units for REIT shares, which are more readily traded on the public market.

Example: A mid-sized investment firm may plan for a strategic liquidity event. By holding UPREIT units, the firm retains flexibility and can convert to REIT shares when market conditions are favorable, allowing them to realize gains without the rigidity of illiquid real estate assets.

4. Operational Efficiency and Scale
By merging their assets into a larger portfolio, investors can benefit from economies of scale, improved management, and more robust market positioning that only large REITs can offer.

Example: A developer with multiple commercial properties might find that joining a REIT not only offers tax benefits but also provides access to professional management and better negotiation power in the market, ultimately leading to improved returns on the overall portfolio.

Disadvantages and Potential Pitfall

1. Limited Control Over Individual Assets
Once property is contributed to the operating partnership, individual control over asset management decisions is typically ceded to the REIT.

Example: An investor who highly values hands-on management may feel restricted after participating in a 721 Exchange, as strategic decisions are now made by the REIT’s management team rather than by the investor.

2. Illiquidity of Partnership Units
Although the eventual conversion to REIT shares offers liquidity, the partnership units themselves are not as easily traded.

Example: A business owner who might need quick access to cash in an economic downturn could find the holding period for converting units into liquid shares to be a disadvantage, especially if market conditions are not favorable at the time.

3. Potential for Conversion Restrictions and Delays
The conversion from partnership units to REIT shares is usually subject to specific holding periods and market conditions.

Example: An investor planning to exit within a short timeframe may be hindered by these restrictions, as the conversion process might not align with their liquidity needs or market exit strategy.

4. Market Risks and REIT Performance
As with any investment, the overall performance of the REIT affects the value of the partnership units. Poor management decisions or market downturns could impact returns.

Example: If a REIT underperforms due to mismanagement or economic challenges, the value of the converted REIT shares might not reflect the initial tax-deferred benefit, leading to potential investor dissatisfaction.

How It Compares to the 1031 Exchange

While both the 721 Exchange and the 1031 Exchange aim to defer capital gains taxes, they cater to different investor needs:

• Direct Property Swap vs. Partnership Structure: A 1031 Exchange involves a direct swap of one property for another “like-kind” property. In contrast, the 721 Exchange involves contributing property into a REIT structure. This difference means that 1031 Exchanges might be preferable for investors who wish to maintain direct ownership and control of their assets.
• Portfolio Diversification: The UPREIT structure often results in a more diversified portfolio managed by professionals, whereas a 1031 Exchange keeps the investor concentrated in real estate assets that they select and manage themselves.
• Liquidity Considerations: The eventual conversion of UPREIT partnership units into publicly traded REIT shares provides a liquidity avenue that a 1031 Exchange might not offer, especially if the investor is locked into a property that is less liquid.
• Strategic Flexibility: Investors with long-term horizons might lean towards a 721 Exchange to benefit from diversification, tax deferral, and potential operational efficiencies, while those seeking immediate reinvestment into another property might prefer the 1031 route.

Final Thoughts

The 721 Exchange (UPREIT) offers a sophisticated and tax-efficient method for investors to diversify their real estate holdings, benefit from professional management, and eventually achieve greater liquidity. By deferring capital gains taxes and converting direct real estate assets into partnership units, investors can focus on long-term growth and strategic reinvestment.

However, as with any strategy, there are trade-offs, including reduced control over individual assets and potential liquidity constraints in the short term.

For professionals and institutions, the 721 Exchange can be a powerful tool when used as part of a broader portfolio strategy. It not only addresses tax efficiency but also enhances operational scale and market flexibility.

When compared with the 1031 Exchange, the UPREIT structure stands out for its ability to offer a diversified, professionally managed pathway to liquidity—making it an attractive option for those looking to elevate their real estate investment strategies in a competitive market.