Exchange Alternatives with UPREITs and 721 Exchanges

For real estate investors, the 1031 Exchange is one of the most well-known tools for deferring capital gains taxes when selling and reinvesting in new property. But what if you want to transition from owning individual real estate to owning shares in a professionally managed real estate portfolio—such as a Real Estate Investment Trust (REIT)?

That’s where the 721 Exchange, also known as an UPREIT transaction, can come into play.

Understanding the 721 Exchange

A 721 Exchange refers to Section 721 of the Internal Revenue Code, which allows investors to defer capital gains taxes by contributing property to a partnership in exchange for ownership interests in that partnership—most often an Operating Partnership (OP) of a REIT.

This type of transaction is sometimes called an “UPREIT,” short for Umbrella Partnership Real Estate Investment Trust.

In an UPREIT structure, the REIT owns interests in the Operating Partnership, and investors can contribute their property to that partnership in exchange for Operating Partnership units (OP units) instead of cash.

How a 721 Exchange Works

Here’s how the process generally unfolds:

1. An investor owns appreciated real estate held for investment.

2. The investor contributes the property to the REIT’s Operating Partnership.

3. In exchange, the investor receives OP units, which represent an ownership interest in the partnership.

4. The investor can later convert those OP units into REIT shares, typically on a one-for-one basis, subject to certain restrictions.

This exchange defers capital gains taxes, similar to a 1031 Exchange, because the investor has exchanged property for a partnership interest rather than selling it outright.

721 Exchange vs. 1031 Exchange

While both strategies allow for tax deferral, they serve different purposes and have distinct structures.

Feature 1031 Exchange 721 Exchange (UPREIT) IRS Code Section §1031 §721 Type of property exchanged Real property for real property Real property for partnership (OP) units Ownership after exchange Direct ownership of real estate Indirect ownership through partnership units Tax deferral Yes, if structured properly Yes, until OP units or REIT shares are sold Liquidity Low to moderate Potentially higher once OP units convert to REIT shares Use of Qualified Intermediary Required Not required Ideal for Active investors seeking continued real estate ownership Investors transitioning to passive income and diversification

Combining 1031 and 721 Strategies

Many investors use a two-step approach to access REIT ownership while still benefiting from a 1031 Exchange:

1. Complete a 1031 Exchange into a qualifying Delaware Statutory Trust (DST) or property.

2. Later, the DST or property is contributed to an UPREIT structure via a 721 Exchange.

This strategy allows investors to first defer gains using a 1031 Exchange and later transition into passive REIT ownership, often with access to diversified real estate portfolios and potential liquidity.

It’s important to note that once a property is converted into OP units, you can no longer exchange those units under 1031—the tax deferral continues only until the REIT shares are sold.

Benefits of a 721 Exchange

• Tax deferral: No immediate capital gains tax triggered at the time of the exchange.

• Passive income: Receive distributions from the REIT without active property management.

• Diversification: Gain exposure to multiple property types and markets.

• Estate planning flexibility: Heirs often receive a step-up in basis at death, potentially eliminating deferred gains.

Key Considerations

While 721 Exchanges offer attractive benefits, investors should understand the trade-offs:

• Once property is contributed to an UPREIT, it generally cannot be reclaimed.

• OP units are subject to REIT management decisions and may have lockout periods before conversion to shares.

• The value of OP units and future REIT shares depends on market conditions and REIT performance.

• Investors relinquish direct control over the real estate asset.

Because of these complexities, 721 Exchanges are typically best suited for investors who are transitioning from active property management to passive real estate ownership.

The Bigger Picture for Investors

A 721 Exchange offers an alternative path for investors who want to move from direct property ownership into a diversified, institutionally managed REIT portfolio—while still deferring taxes. For those nearing retirement, seeking passive income, or wanting to simplify portfolio management, it can be a strategic next step after years of active investing through 1031 Exchanges.

However, investors should weigh the long-term implications—especially the loss of direct control and limited liquidity—and consult tax and legal advisors to ensure the move aligns with their financial goals.