How 1031 and 721 Tax-Deferred Exchanges Work
During the 2000s, when the real estate market was hot, I was the accountant for a real estate developer who brought together Brazilian investors. They would each contribute $150,000, which then was used to leverage a loan for the development of an office condominium. He would build the complex and the investors would own an interest in one of the condos.
When the project was completed, the developer would sell the units that he had kept for himself and then reinvest those profits into his next project. He did this over and over again until he had built up an entire street in Orlando.
As his accountant, I was looking for ways to mitigate his tax liability. I was relatively new to the profession then, and right around that time I happened to take a continuing professional education course on Internal Revenue Code Section 1031 exchanges. I realized this was perfect for my client, so I called a meeting with him. He loved the idea and began talking to his investors that were selling their properties and reinvesting the profits into the next development project. Soon they all began doing 1031 exchanges.
How does a 1031 exchange work? It can be very complicated, but basically a true 1031 exchange (like-kind exchange) works like this: A true like-kind exchange is when one property owner and another property owner have substantially the same property, and they exchange deeds. This is in the textbook, but in 23 years, I have never seen a like-kind exchange work exactly this way.
What happens in the real world is that a property owner sells his or her property. The proceeds of the sale are then held by a qualified intermediary. This is not to be confused with another IRS qualified intermediary.
In a like-kind exchange, a qualified intermediary can be anyone except your accountant, lawyer, or immediate family. Within 45 days, you must identify to the qualified intermediary up to three replacement properties. Then within 180 days, or the due date of the tax return including extensions, you have to take possession of the replacement property. Doing this avoids capital gains tax. There is no law written, but several US Tax Court cases have stated that the replacement property should be held for at least two tax returns.
This was perfect for my client. It usually took him up to two years to build the properties, so it was a win-win.
I eventually became the accountant for the other investors and I constructed reverse exchanges, forward 1031 exchanges, leasehold improvement exchanges, multi-asset 1031 exchanges, and mixed-use 1031 exchanges (told you they got complicated). I charged a good fee, but my clients were happy.
Then the real estate bubble came and the main client lost his shirt, along with his investors. I lost all the clients because they simply went out of business – all of them except one, who started his own development company and is still a client today.
I keep up with real estate tax law because it is completely different from other businesses. In fact, it is back in full swing again. And I found a new tool in Section 721 exchanges. Let me explain.
A real estate investment trust (REIT) is very similar in concept to a mutual fund that invests in real estate and real estate-related assets. Investors buy shares or units in the REIT, and the REIT, in turn, buys other real estate. Therefore, a REIT is considered a security and can be publicly traded (bought and sold) like any other publicly traded stock, bond, or mutual fund. Or, it can be privately traded and bought or sold through registered representatives that specialize in nonpublicly traded REITs.
REITs generally acquire and own numerous investment real estate properties that provide investors with a well-diversified investment real estate portfolio. REITs are also well-known for providing handsome cash flows in the form of dividends paid to investors, which are tax-free to the investor.
An umbrella partnership real estate investment trust, usually referred to as an UPREIT or a 1031/721 exchange, can provide virtually the same tax-deferred benefits to real estate investors that a like-kind exchange provides when they contribute their investment real estate property into a new ownership structure that includes an operating partnership with a REIT. Investors can effectively dispose of real estate and acquire an interest in a REIT on a tax-deferred basis by taking advantage of the UPREIT strategy.
An investor can do a pure 721 exchange that involves a direct contribution of the investor’s real property into an operating partnership REIT, in exchange for interest in the operating partnership. Just like a true like-kind exchange, this rarely happens. So, a strategy has to be devised.
An UPREIT is basically structured as a two-step process. The first step uses a 1031 exchange and then a subsequent exchange of the money into a REIT. It involves selling the relinquished property and structuring a 1031 exchange. However, instead of searching for suitable replacement property, the investor would identify and acquire a fractional interest (tenant-in-common interest) in real estate that the REIT has already designated. This completes the 1031 exchange portion of the transaction.
The second step is to contribute the fractional interest into the operating partnership after a holding period of 12 to 24 months as part of a 721 exchange (tax-deferred contribution into a partnership). The investor receives an interest in the operating partnership in exchange for his or her contribution of the real estate and is now effectively part of the REIT.
Just like 1031 exchanges, 721 exchanges have their own rules and regulations that need to be followed. What I’ve laid out for you are the basics of each transaction.
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Craig W. Smalley, MST, EA, has been in practice since 1994. He has been admitted to practice before the IRS as an enrolled agent and has a master's in taxation. He is well-versed in US tax law and US Tax Court cases. He specializes in taxation, entity structuring and restructuring, corporations, partnerships, and individual taxation, as well as...