About 721 Exchanges

Summary

UPREIT transactions (via a 721 exchange) most often happen in two structures:

1. An investor contributes their asset to a REIT in exchange for REIT partnership interests.

2. An investor purchases interests in a DST (via a 1031 exchange) and the DST is in turn contributed to the REIT, giving investor shares in the REIT operating partnership.

RCX believes the second scenario better aligns with most investors because it is imperative that investors evaluate the underlying assets in the REIT as they will have ownership in the REIT partnership which has exposure to each asset in the portfolio. Because of this, RCX believes that investors may receive ownership in a higher quality portfolio by purchasing DST interests first rather than contributing their personal investment property to a REIT.

How Does it Work?

The investment strategy of an UPREIT, sometimes referred to as a 721 Exchange, has two distinct phases.

1. The first phase is actually structured as a Delaware Statutory Trust (DST) backed by the REIT. Similar to a traditional DST investment, the first phase allows the investor to successfully complete his or her 1031 exchange.
   

2. During the second phase, the DST is purchased by the REIT and the DST interests are transferred for OP (operating partnership) units, which investors can hold on a tax-deferred basis for as long as they want.

UPREITs use call options and transitions from DST interests to OP units. The UPREIT property (held in a DST) is purchased by the REIT via a call option that the sponsor holds at fair market value. The fair market value is determined by an independent third-party appraisal. This process begins 24 months from the date the last investor acquires an interest in the DST. Once the call option is exercised, investor’s DST interests are exchanged for OP units in the REIT. Investors can then hold their OP units and collect distributions from the REIT or choose to transfer those OP units for REIT shares and liquidate them.

Investors can hold onto the OP units for as long as they like. Once they decide to transfer their OP units for REIT shares and then simultaneously liquidate those shares, there is no opportunity for a subsequent 1031 exchange.

Once the OP units are redeemed into REIT shares, the investor must pay capital gains taxes.

Benefits and Shortcomings of 721 Exchanges

UPREITs may provide a solution for exchangers who may not have the time, energy, interest, or real estate expertise to find and/or manage replacement property.

Conclusion

There are distinct differences between the traditional DST structure and a DST that intends to be contributed to a REIT via a 721 exchange. Each investor must take into consideration that fact that REITs may not have liquidity when they want it, and that taxes will ultimately be paid when liquidity is taken.

RCX believes the sources relied upon herein are reliable, but takes no responsibility for its accuracy.