IBA, as the premier business brokerage firm in the Pacific Northwest, is firmly established as a respected professional service firm in the legal, accounting, banking, mergers & acquisitions, real estate, and financial planning communities. Periodically, we will post guest blogs from professionals with knowledge to share for the good of owners of privately held companies & family businesses. The following content has been provided by Marc Bannos. Mr. Bannos is a Registered Investment Advisor with Equilus Group, Inc. (www.equiluscapital.com), an independent registered advisory firm. He entered the financial services industry in 2015 and worked for several large wirehouse firms and big banks prior to entering the independent world. Including 1031 alternatives & personal financial planning services, he specializes in the administration of business retirement plans, estate & succession planning.
The 721 Exchange: An introduction to 1031 Alternatives
As a licensed professional in good standing with FINRA and the SEC, I need to start this article with a short disclosure before getting to it… The 721 Exchange (or other 1031 alternatives) may be a suitable strategy for those reading, but this article is for educational purposes only and not meant to be taken as financial advice or a recommendation. If you feel as though the information provided may be applicable to your situation, please contact me at firstname.lastname@example.org for a private consultation.
It’s an understatement to say that we all must adapt to changing times, especially when looking at the past couple of years. With the pandemic having changed the way most of us conduct business, socialize, or even dine, we can all agree that it’s crucial to know how to adapt to the new normal. While all of us know how important it is to be flexible, we all still appreciate it when some things just stay the same. One of the key platforms the new administration ran on was tax reform, and with the passing of the infrastructure bill, it appears that government will soon shift focus back to that. As of 2021, many property investors and business owners reading may be aware that the new administration is discussing limiting the amount one can defer on a 1031 exchange ($500,000 for each taxpayer, up to $1 million for joint filers) and increasing the long-term capital gains tax from 20% to 39.6%. What you may not know though is that there is a strategy currently exempt from this proposal; enter the 721 Exchange.
What is the 721 Exchange?
The 721 Exchange, surprisingly, isn’t new. It stems from section 721 of the IRS tax code and has been a viable strategy for over 50 years. Simply put, it allows one to transfer an investment property into a Real Estate Investment Trust (REIT) or Umbrella Partnership Real Estate Investment Trust (UPREIT). The end-result of a 721 and 1031 exchange are the same; the investor defers capital gains taxes on an appreciated investment property. A 721 exchange isn’t as simple as just selling a property and parking the funds in a REIT after the fact, however. Most facilitators, including my firm’s real estate arm, Equilus Capital Partners, will want to run a certified appraisal of the property and will work with the investor and their legal/tax team to ensure a smooth and compliant exchange. While 1031 exchanges may be seeing limits, a 1031 exchange will still sometimes be utilized to purchase a fraction of the proposed property and held for 2 years to handle “look back” provisions before being exchanged for REIT/UPREIT shares with the rest of the 721 proceeds.
721 Benefits and Other Information
If completing a 721 exchange and receiving shares from the property, one must understand that (UP)REIT shares are not eligible for a 1031 exchange. Once you receive the shares, that’s that. Congratulations, you’ve now deferred 100% of the capitals gain and depreciation recapture tax from your property but have also gained some additional advantages, namely diversification, passive income, liquidity, control, and a new source of depreciation. See below for a short summery.
- Diversification- Rather than just one property, the investor now has passive interest in many additional investment grade commercial properties.
- Passive Income- REITs/UPREITs generally tend to pay high dividends on a quarterly or monthly basis.
- Liquidity- After a 721 exchange is completed, the full value of the original property is exchanged for shares. It is recommended to hold the shares for at least 2 years, but if you need funds, there’s no rule against selling out.
- Control- You decide when (or if) you sell. While the shareholder will still pay taxes on dividend income from the REIT/UPREIT, they don’t have to realize capital gains until they’re ready.
- Depreciation- A 721 exchange still allows for the investor to use depreciation to offset the income derived from an UPREIT. Hypothetically, if one is receiving $50,000 a year in dividend income and their depreciation offset for the year is $10,000, they’ll only be paying taxes on $40,000 worth of income.
With the potential cuts coming to 1031 exchanges, powerful and underutilized strategies like the 721 exchange still exist to provide tax deferral for property investors and business owners. More importantly, even if the new administration does not enact laws limiting the benefits of a 1031 exchange, the 721 provides benefits that the 1031 does not, namely liquidity and the opportunity to divest from physical real estate. There are a few other 1031 alternatives I can go over, but I’ll save those for the next article. For now, I’m glad to create awareness around a little-known gem.
If you have questions relating to 721 Exchanges, the content of this article, or issues wealth advisory, Marc Bannos would welcome the opportunity to talk with you. Mr. Bannos can be reached at (888) 860-0658 or email@example.com.
IBA, the Pacific Northwest’s premier business brokerage firm since 1975, is available as an information resource to the media, business brokerage, mergers & acquisitions, and real estate communities on subjects relevant to the purchase & sale of privately held companies and family owned businesses. IBA is recognized as one of the best business brokerage firms in the nation based on its long track record of successfully negotiating “win-win” business sale transactions in environments of full disclosure employing “best practices”.