721 Exchanges – The lesser known tax strategy


Most practitioners are at least familiar with 1031 exchanges even if they haven’t dealt with many of them personally. 1031 exchanges generally allow for like-kind property to be exchanged and any gain deferred. The most common example of this would be the idea of trading in a vehicle.

If a taxpayer trades in a business use vehicle for a new one, and receives a value at the time of trade-in that exceeds the book value, the taxpayer has a gain. That gain will then reduce the basis of the new vehicle as opposed to the entire gain being recognized that year.

A much less known, and less utilized strategy is 721. In addition to deferring gains, 721 exchanges potentially allows your client to expand their real estate portfolio across a collection of more diverse assets than would be provided in a 1031 exchange scenario.

The biggest difference between the two strategies is that 721 requires the formation of an umbrella partnership which effectively holds the assets. In exchange for investors contributing the ownership interest in their real estate, they receive units in the umbrella partnership. The partnership could then effectively hold an unlimited number of properties, of which, each partner holds their own shares to.

These types of partnerships allow not just for more diversity in each partner’s portfolio, but also provides more liquidity in the event that a partner is looking to utilize the investment for a specific purpose and needs to cash out. The investors also receive the benefit of deferred gain on their initial property contributions.

Most real estate investment trusts can take advantage of umbrella partnerships to offer these benefits to potential investors. The strategy is of course confined to an investors ability to find an UPREIT that fits their investment goals, however practitioners, especially those with a large real estate investment clientele, should be aware of the strategy as an alternative to 1031 exchanges.

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