721 UpREIT’s

Owners of real estate properties looking for an exit strategy and the opportunity to diversify their real estate holdings while deferring capital gains taxes may find utilizing IRC Section 721 (a “721 Transaction”), also referred to as an “UPREIT Transaction”, to be a preferred tax mitigation strategy. Rather than exchanging property for property, a 721 Transaction allows an investor to contribute property directly to a REIT’s operating partnership (the entity through which the REIT acquires and owns its real estate) in exchange for operating partnership units (“OP Units”). This type of transaction may be especially helpful for property owners with significant gains where a sale would trigger a taxable event, or for those looking for an estate planning tool that efficiently passes down highly appreciated real estate in a tax-efficient manner among heirs. A 721 Transaction may also be a viable option for those who wish to diversify away from potential uncertainties surrounding the future of IRC Section 1031.

A DST 721 OR “TWO-STEP” TRANSACTION

The typical real estate investor does not hold real estate that a REIT would want to acquire in an UPREIT Transaction. However, the possibility of acquiring OP Units for a real estate investment may be achievable to investors indirectly through a Section 1031 exchange into a Delaware Statutory Trust (“DST”). Interests in a DST (“DST Interests”) are fractional interests in real property, such as a multifamily property, typically acquired by investors seeking replacement property to defer gain that was realized on a disposition of a relinquished investment property.

In this scenario, the investor sells his investment property to a third party and uses the proceeds from the sale to purchase a DST Interest equal to the value of the relinquished property. Because DST Interests are treated as investment property for US tax purposes, a REIT that wants to acquire a property held by a DST can cause its operating partnership to acquire all the DST Interests from their holders in exchange for OP Units. Exchanging into DST Interests therefore can open access to institutional-grade real estate held by a DST, and thereby open access to the more diversified real estate portfolios held by REITs in their UPREIT structures.

The investors that contribute their DST Interests to an operating partnership will be treated as having contributed investment property to the operating partnership in a 721 Transaction (a “DST 721 Transaction”). A DST 721 Transaction should generally not occur less than two years after the initial acquisition of the DST Interests by their holders, nor can there be any promise or guarantee, at the time of such initial acquisition, that the DST 721 Transaction will occur.

A 721 Transaction (whether involving a DST or otherwise) can be used in conjunction with public, private, or publicly registered non-traded REITs, each of which has unique investment characteristics to consider. It is important to understand that at the time an investor converts OP Units for shares in the REIT to get liquidity, a taxable event occurs and there is no longer an opportunity to defer taxes. However, this conversion will normally take place at the discretion of the investor or estate and may often occur after a step-up in cost basis in the event of the investor’s death.