721 Exchange vs 1031 Exchange

The real question: keep trading, or stop

People compare a 721 exchange and a 1031 exchange as if they were rivals. They are two different tax tools that often run in sequence. A 1031 exchange defers gain by replacing real property with real property. A Section 721 contribution defers gain by contributing property to a partnership for a partnership interest (IRC 721(a)). The first keeps the door to future exchanges open. The second closes it.

This page compares one specific choice: keep rolling into a Delaware statutory trust and then another, or convert into operating partnership units of a REIT. It covers tax facts only. It is not a view on any trust, REIT, sponsor or offering, and Hans does not sell securities.

The merits of any interest are for your securities and legal professionals. The short route question, "can you 1031 into a REIT," is answered at 1031 exchange into a REIT.

Tax at each step

Repeat exchanges. The trust interest qualifies as the replacement property because the IRS ruled in Rev. Rul. 2004-86 that a properly limited Delaware statutory trust is an investment trust whose owners are treated as owning the real estate. Each exchange carries your old basis into the new interest, including the deferred depreciation recapture. Nothing is taxed until you sell for cash without exchanging again, or die.

Conversion to units. The contribution is not taxed (IRC 721(a)), but several traps sit around it. Cash or debt relief within two years can be presumed to be a disguised sale (IRC 707(a)(2)(B); Treas. Reg. 1.707-3). A drop in your share of partnership debt can be a deemed distribution (IRC 752, 731).

If the partnership sells the property you contributed, your built-in gain is allocated to you (IRC 704(c)). A transfer to a partnership that would be an investment company if incorporated is not covered (IRC 721(b)); that is rarely an issue for real estate.

Redeeming units for cash, or exchanging them for REIT shares, is a taxable event (IRC 731, 741). The tax is deferred for as long as the units are held, but it is not deferred by an exchange.

Future 1031 exchanges

This is the cleanest difference. A Delaware statutory trust interest is treated as real property for Section 1031, so when the trust sells you can exchange again if you reinvest within the deadlines. Operating partnership units are partnership interests, and Treas. Reg. 1.1031(a)-3(a)(5) excludes partnership interests from real property. After a 721 contribution, no later sale of units can be a 1031.

If you may still want to buy a building, trade up, or move to another state, that option has value that the contribution gives up for good.

Deadlines and decisions at an older age

Each 1031 exchange has an identification deadline 45 days after you transfer the property you give up, and a closing deadline of 180 days or the return due date, whichever is earlier (IRC 1031(a)(3); Treas. Reg. 1.1031(k)-1). That is manageable once.

A chain of exchanges means the same decision again each time a trust sells, usually on the sponsor's schedule rather than yours, at whatever age and health you have then. A missed deadline turns the sale into a taxable one.

A Section 721 contribution has no statutory 45-day or 180-day clock. The decisions come earlier: whether to contribute, what the holding period and redemption terms are, and when to redeem. If an offering gives the operating partnership an option to take the trust's property for units, the contribution can happen on the sponsor's timetable, not yours; read the memorandum for who holds the option.

Step-up at death

Both paths can end with the same result. Property acquired from a decedent generally takes a basis equal to its fair market value at death (IRC 1014(a)). Heirs of a trust interest or of units can therefore start with a new basis, which can erase the gain you deferred.

The step-up depends on holding until death and on how the estate is set up. Selling or redeeming before death gives it up.

For an installment sale, by contrast, the unpaid note generally gets no step-up (IRC 691). That difference is one reason the full comparison matters. See step-up at death and 1031 vs installment sale.

Diversification, access to money and control

Diversification. One trust usually holds one property or a small portfolio, so a chain of exchanges can concentrate in the properties and sponsors you pick. Units give you a slice of an operating partnership that owns many properties. Spreading one exchange across several offerings narrows that gap on the exchange side.

Access to money. Neither is liquid. A trust interest has no public market and the sponsor sets the sale date. Units can be redeemed under the partnership agreement, usually after a holding period and often at the REIT's choice of cash or shares.

The SEC's Office of Investor Education says non-traded REIT redemption programs are typically subject to significant limitations, may be discontinued without notice, and may redeem at a discount (SEC investor bulletin on non-traded REITs; undated, so check the current version).

A listed REIT's shares trade on an exchange, but the exchange of units for those shares is taxable.

Control. In a trust, the trustee's powers are frozen by design: no refinancing, no new capital, no lease renegotiation. A springing conversion to an LLC clause can protect the property but can end eligibility for the next 1031.

With units, the partnership can sell your contributed property, which triggers your built-in gain unless a tax protection agreement covers it. In both you give up control; what differs is whether the trigger is the sponsor's sale or the partnership's.

Costs: repeated entry costs or ongoing fees

The two structures charge in different places. Each new trust offering has its own selling costs and sponsor fees, shown in the sources and uses table of its private placement memorandum, so a chain of exchanges pays entry costs more than once.

I could not verify a standard figure for those costs from a regulator, so read that table line by line.

Inside a REIT, the SEC's Office of Investor Education says non-traded REITs typically charge high upfront fees that can represent up to 15 percent of the offering price, plus acquisition and asset management fees (SEC investor bulletin; undated).

Units issued in a contribution may not carry the same upfront load, but ongoing partnership and advisory fees apply. Ask for the all-in cost in writing for whichever you consider.

Who each tends to fit, as tax facts

• Repeat exchanges tend to fit an owner who wants to defer, expects to hold real property for years, and can handle the deadlines on each exchange, or who wants the option to leave real estate later with an installment sale on the boot.
• Conversion to units tends to fit an owner who is done trading, wants one decision instead of a chain, expects to hold until death, and accepts that exits are taxable.
• Neither fits an owner who needs most of the money soon, wants to choose the sale date, or wants out of real estate entirely. A cash sale or an installment sale is the tool to compare.

These are tax facts, not advice about any security. To model them with your numbers, get the Big Sale Tax Analysis.

Frequently asked questions