In this episode, we're joined by Warren Thomas, a CPA and professional with extensive experience in estate planning, financial planning, and real estate advisory services. He is currently a managing partner at Exchange Right, a company that provides real estate investments that target secure capital, stable income, and strategic exits in order to protect and grow wealth. Today we discuss an exit strategy called a Section 721 Exchange, also known as an UPREIT transaction.

In summary, UPREIT transactions allow investors to sell their property and defer their capital gains tax by buying a fractional ownership interest in an institutional grade property in a Delaware Statutory Trust, then using a 721 exchange to essentially acquire shares of a REIT, all while deferring capital gains tax.

Section 721 Exchange

721 exchanges can be used in a variety of ways, but essentially provide that you have no gain or loss recognized when you contribute your property into a partnership or an operating partnership of a REIT. As long as you contribute your property to a partnership structure, the IRS isn't going to require you to recognize that gain. This can be done with any partnership, you just must exchange real estate for real estate. You cannot exchange your property for a partnership interest - there is a distinction between becoming a partner and just taking partnership shares, and you cannot use cash, it must be the property.

Delaware Statutory Trust (DST) Involvement 

The DST comes into play by allowing you to use the cash proceeds from the sale. First, the investor would use a 1031 exchange to move the proceeds from the property into a DST. Next, after 3-5 years, the DST will contribute the holdings into the operating partnership of a REIT in exchange for the shares of the REIT. This is the two-step process. The 3-5 years is necessary because you must be careful with these prearranged or guaranteed transactions. The IRS may view this transaction as negating the 1031 exchange; it's very important for the 1031 exchange to take place successfully.

In a perfect world, the asset that the investor is looking to roll into the REIT is homogenous or in agreement with the current holdings of the REIT. In this scenario, the REIT could offer a 721 exchange directly to the investor, and the REIT could take control of the asset. In this scenario, the DST is not necessary because the asset is the type of asset that the REIT is looking to hold outright, as-is.

Why are Investors Interested?

Investors are interested in diversification and joining forces with other professionals in the industry. This strategy also offers more stable cash flow, investment grade tenants, and other characteristics of REITs that are more favorable than a single property. This strategy further mitigates your risk - higher credit for tenants, more locations and exposure to more markets, and lower lease rollover risk because there's a larger number of leases. In one word, diversification is the reason. With the 721 exchange, there can even be liquidity provisions, enabling investors to request cash for shares. The exit plan of the REIT is either merging with a larger REIT or creating a public offering/IPO.

With the IPO, at first you'll merge your operating units into the publicly-traded REIT. This is a tax-deferred 721 occuring again. Once you're there, you can move your operating units into REIT shares for daily liquidity.

Shares of a REIT

The pros are diversification and flexibility in rolling funds into the next deal. The biggest con to the 721 is that you cannot exit with another 1031 exchange in the future.

Your REIT shares will pick up a carryover basis from your original 1031 exchange basis. Whatever your tax basis was in the old basis, if you roll it into the 721, that becomes your tax basis in the new asset. This basis is allocated across all units in the REIT. If you decide to sell some shares, you go back to the same ratio to recognize gain.

Costs

Costs depend upon how you're executing the 721 exchange. A typical REIT, absorbing your property, you'll simply have legal costs and a negotiated sale that you work on with the REIT. In the DST strategy, there are almost 0 costs. The DST manager is absorbing assets into a structure that already exists. DST's typically have a very low threshold for entry, with entries from $100,000 to $10MM+. There is a wide variety of investors here.

Learn more about Warren and Exchange Right: https://www.exchangeright.com/

You can also contact Exchange Right by phone: 1-855-317-4448 or by email: info@exchangeright.com