What is the difference between a 1031 Exchange and a 721 Exchange?
When it comes to deferring taxes and reinvesting real estate gains, investors have more than one option under the Internal Revenue Code. Two of the most notable strategies are the Section 1031 Exchange and the Section 721 Exchange, also known as an “UPREIT” exchange. While both offer tax-deferral benefits, they operate differently and serve distinct investment objectives.
This article explains how each structure works and outlines their key similarities and differences.
What Is a 1031 Exchange?
A 1031 Exchange, named after Section 1031 of the Internal Revenue Code, allows real estate investors to defer capital gains taxes when selling investment or business property—provided the proceeds are reinvested into another like-kind property of equal or greater value.
To qualify for full tax deferral, investors must follow several IRS rules, including:
Both the relinquished and replacement properties must be held for investment or business use.
The investor must identify the potential replacement property within 45 days of selling the original property.
The exchange must be completed within 180 days.
Most importantly, sale proceeds must never be received directly by the investor. Instead, they must be held by a Qualified Intermediary (QI)—a neutral third party responsible for facilitating the exchange and ensuring compliance with IRS regulations.
By meeting these requirements, investors can defer capital gains, depreciation recapture, and even the Net Investment Income Tax (NIIT) tied to those gains.
What Is a 721 Exchange (UPREIT Transaction)?
A 721 Exchange, derived from Section 721 of the Internal Revenue Code, allows property owners to contribute real estate to a Real Estate Investment Trust (REIT) operating partnership in exchange for Operating Partnership (OP) units.
This transaction is often referred to as an “UPREIT” (Umbrella Partnership Real Estate Investment Trust) structure. The main advantage is that investors can defer capital gains taxes while converting their real estate ownership into a diversified, passive investment within the REIT structure.
Over time, these OP units may be converted into publicly traded REIT shares, which can later be sold—triggering a taxable event when that conversion occurs.
Key Differences Between 1031 and 721 Exchanges
| Aspect | 1031 Exchange | 721 Exchange |
|---|---|---|
| IRS Code Section | Section 1031 | Section 721 |
| Primary Goal | Defer taxes through reinvestment in like-kind real estate | Defer taxes through contribution to a REIT partnership |
| Ownership Outcome | Direct ownership of physical property | Indirect ownership via OP units in a REIT |
| Eligible Property Type | Real property held for investment or business use | Investment property contributed to a REIT’s partnership |
| Liquidity | Low — investor continues to hold real property | Higher — OP units may later be converted to REIT shares |
| Investment Style | Active ownership and management | Passive investment in a managed portfolio |
| Future 1031 Eligibility | Property can continue to be exchanged under 1031 rules | Once contributed to a REIT, it generally cannot be exchanged again under 1031 |
How the Two Strategies Can Work Together
Some investors choose to combine both strategies to achieve long-term flexibility. For example, an investor might first complete a 1031 Exchange to defer taxes while upgrading or diversifying their property holdings. Later, they can contribute that property to a REIT through a 721 Exchange, transitioning from active ownership to a more passive investment while maintaining deferred tax status.
This approach provides a bridge between hands-on real estate investing and portfolio-style real estate ownership through a REIT.
IRS Compliance and the Role of Professionals
Both 1031 and 721 Exchanges are governed by specific IRS rules and require careful structuring to maintain tax deferral. Investors should pay close attention to:
Intent to hold for investment — the property must not be primarily held for resale.
Strict timing rules — particularly the 45-day identification and 180-day exchange completion windows in a 1031 Exchange.
Use of a Qualified Intermediary (QI) — required for all delayed 1031 Exchanges to handle proceeds and ensure compliance.
Loss of future exchange eligibility — once a property is transferred into a REIT through a 721 Exchange, it typically cannot be exchanged again under Section 1031.
Because of the technical nature of these transactions, it’s highly recommended that investors consult with a Qualified Intermediary, as well as tax advisors and legal professionals, before initiating either exchange type.
Putting It All Together
Both 1031 Exchanges and 721 Exchanges are powerful tools for building and preserving real estate wealth through tax-deferred strategies.
A 1031 Exchange best suits investors seeking to stay actively involved in property ownership, while a 721 Exchange appeals to those looking for passive income through a professionally managed REIT. Understanding how these two exchanges differ—and how they can complement each other—can help investors make informed, strategic decisions aligned with their financial goals.
Disclaimer
This article is for informational purposes only and does not constitute legal, tax, or financial advice. Investors should consult with a Qualified Intermediary, CPA, or legal professional experienced in real estate exchanges before making any decisions related to Section 1031 or Section 721 transactions.
