Everything You Need to Know About IRS Section 721 Exchange and UPREIT | DST Investment

If you have ever done a 1031 exchange, also known as a Like-Kind exchange, you are familiar with the process of selling one property and using the proceeds to buy another property. But what if you want to sell your investment property and use the proceeds to purchase shares in a Real Estate Investment Trust (REIT)? 

In this article, we will discuss Section 721 of the Internal Revenue Code and how it applies to REITs. We will also discuss UPREITs, which are a type of REIT that allows you to defer capital gains taxes on the sale of your property.

What is Section 721?

Section 721 of the Internal Revenue Code is also known as the Non-Recognition Provision. This section provides that no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or investment if such property is exchanged solely for stock in a corporation. 

For the exchange to qualify under Section 721, the following requirements must be met:

  • The property must be exchanged for stock in a corporation.
  • The property must be held for productive use in a trade or business, or investment.
  • The exchange must be solely for stock in a corporation.

If these requirements are met, then the gain or loss on the sale of the property will not be recognized for tax purposes. 

What is a REIT?

A REIT is a type of investment vehicle that allows you to invest in real estate without purchasing or managing properties yourself. REITs are required to distribute at least 90% of their taxable income to shareholders in the form of dividends. 

REITs can be publicly traded on major exchanges, such as the New York Stock Exchange, or they can be private. There are also several different types of REITs, such as office REITs, retail REITs, residential REITs, and industrial REITs. 

What is an UPREIT?

An Umbrella Partnership Real Estate Trust, known as UPREIT, is a type of REIT that allows you to defer capital gains taxes on the sale of your property. When you sell your property, you can exchange it for shares in the UPREIT. 

To qualify for the exchange, the following requirements must be met:

  • The property must be exchanged for stock in a corporation that is engaged in a real estate business.
  • If the property is exchanged for stock in a publicly-traded REIT, the shares must be listed on a national securities exchange.
  • The exchange must be solely for stock in the corporation. 
  • If these requirements are met, then the gain or loss on the sale of the property will not be recognized for tax purposes. 

An UPREIT can be a good option if you want to sell your property and defer capital gains taxes. It is also important to note that you will still be responsible for paying dividends on the shares you receive in the exchange. 

Most Common Disqualifications for Section 721

There are a few common disqualifications for the exchange to qualify under Section 721. These include:

  • The property must be exchanged for stock in a corporation. If the property is exchanged for stock in a partnership, the exchange will not qualify.
  • The property must be held for productive use in a trade or business, or investment. If the property is held for personal use, such as a primary residence, the exchange will not qualify. 
  • The exchange must be solely for stock in a corporation. If the property is exchanged for both cash and stock, the exchange will not qualify. 

These are just a few of the common disqualifications for the exchange to qualify under Section 721. It is important to speak with a tax advisor to determine if your exchange will qualify. 

Important Factors to Consider

Estate Planning:

If you consider an exchange under Section 721, it is important to also consider the estate planning implications. When you exchange property for stock in a corporation, you effectively transfer your ownership interest in the property to the corporation. 

This can have gift and estate tax implications if the property’s value is high enough. It is important to speak with a tax advisor to determine if an exchange under Section 721 is right for you from an estate planning perspective. 

Capital Gains Taxes:

Another important factor to consider is capital gains taxes. If you exchange your property for stock in a corporation, you will not be required to pay capital gains taxes on the sale of the property. 

However, you will still be responsible for paying dividends on the shares you receive in the exchange. This is something to keep in mind when considering an exchange under Section 721. 

Liquid Assets:

It is also important to consider the liquidity of your assets when considering an exchange under Section 721. When you exchange your property for stock in a corporation, you are effectively transferring your ownership interest in the property to the corporation. 

This can impact your ability to access cash if you need it in the future. If you are considering an exchange under Section 721, it is important to make sure that you have other liquid assets available in case you need access to cash. 

 

Risks:

There are also a few risks to consider when exchanging property for stock in a corporation. These include:

  • The value of the stock may fluctuate, which could impact the value of your investment.
  •  If the corporation goes bankrupt, you may lose your investment.
  • The corporation may not pay dividends, which could impact your ability to generate income from your investment. 

These are just a few risks to consider when exchanging property for stock in a corporation. It is important to speak with a financial advisor to discuss these risks and how they might impact your investment. 

The Bottom Line

Section 721 of the Internal Revenue Code provides that no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or investment if such property is exchanged solely for stock in a corporation. REITs are a type of investment vehicle that allows you to invest in real estate without purchasing or managing properties yourself. UPREITs are a type of REIT that allows you to defer capital gains taxes on the sale of your property. 

The best way to ensure that your exchange qualifies under Section 721 is to speak with a tax advisor. They can help you determine if your exchange meets all of the requirements and provide guidance on structuring the exchange to maximize the tax benefits. 

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