The Benefits of a Two-Step Process for Real Estate Owners Using IRC 1031 and 721 Exchanges
Owning real estate can be highly profitable, but it also comes with the challenges of active property management, including collecting rents, negotiating leases, dealing with tenants, and maintaining buildings. These responsibilities can become increasingly burdensome, especially as property owners age. Fortunately, a two-step process utilizing Internal Revenue Code (IRC) 1031 and 721 exchanges can provide property owners with access to a professionally managed pool of institutional-quality real estate holdings, offering passive income and deferring capital gains taxes.
Step One: 1031 Exchange to a Delaware Statutory Trust (DST)
Most real estate investors are familiar with the benefits of Internal Revenue Code section 1031, which allows for a tax-deferred exchange of real estate, provided certain conditions are met. Historically, 1031 exchanges required simultaneous property swaps, but modern rules now allow for "delayed exchanges," enabling investors to sell their property before acquiring a replacement. This flexibility is advantageous, but the stringent time requirements for identifying a replacement property within 45 days and closing within 180 days can still be challenging.
To address this, the first step in the two-step process involves using a Delaware Statutory Trust (DST) as the replacement property. Investors can sell their property and use a 1031 exchange to acquire a beneficial interest in a DST. Benefits of DSTs include:
- Trading active real estate management for a passive role
- Access to institutional-quality replacement properties, which may be otherwise out of reach
- Simplified estate planning, as interests in DSTs are easier to pass along than real estate
- Faster closing times, making it easier to meet 1031 exchange deadlines
Step Two: 721 Exchange into a Real Estate Investment Trust (REIT)
The second step involves converting the DST ownership stake into a diversified REIT portfolio through a 721 exchange, also known as "UPREITING." Section 721 of the Internal Revenue Code allows DST owners to exchange their fractional ownership interest on a tax-deferred basis for an interest in the operating partnership of a REIT via an Umbrella Partnership Real Estate Investment Trust (UPREIT) structure.
Potential benefits of a 721 exchange include:
- Continued deferral of capital gains taxes associated with the original property
- Potential for increased tax-advantaged income based on the REIT portfolio’s performance
- Increased diversification with exposure to a professionally managed, institutional-grade real estate portfolio
- Enhanced liquidity through the investment vehicle’s share redemption program
- Simplified inheritance, as REIT common shares are easily divisible and can be held or liquidated by beneficiaries at a stepped-up cost basis, resulting in a permanent tax deferral of capital gains and depreciation recapture
By following this two-step process, property owners can enjoy the advantages of passive fractional ownership in a diversified real estate investment pool while deferring capital gains taxes and potentially enhancing their financial well-being. If you're a property owner seeking to simplify your investment strategy and maximize your financial benefits, exploring the combination of IRC 1031 and 721 exchanges could be the ideal solution.