For building owners and investors looking to avoid long-term capital gains on real estate properties, usually, the only option they see is a §1031 Exchange.
However, another strategy, similar to a §1031, is called a §721 exchange. Both §1031 and §721 exchanges let investors defer capital gains taxes on the sale of a building.
In a §721 exchange, the investor or owner puts their property in an operating partnership in a UPREIT. A UPREIT means Umbrella Partnership Real Estate Investment Trust. A UPREIT is a REIT structure that allows property owners to exchange their property for a share of the ownership in the UPREIT. In exchange for the property, the investor receives equity in the form of units. The units usually have the same value as the property contributed to the UPREIT.
By executing a 721 exchange, an investor can conceivably expand their real estate holdings across much more diverse assets. This allows the owner to diversify their real estate holdings and take advantage of the opportunities vetted by more prominent and seasoned real estate investors.
§1031 allows investors to defer capital gains by exchanging an investment property or properties for another like-kind property of equal or greater value.
Most real estate properties can be designated as like-kind. For example, the relinquished property may be a strip center but can be exchanged for a multi-family or single-family dwelling.
Another option, similar to a §721 exchange, is a Delaware Statutory Trust (DST). A DST is a legal entity with a very open methodology in creating and operating the entity. Investors own an interest in the trust and can receive interest and distributions based on the level of the investment in the trust. This form of ownership also allows an investor to enjoy the benefits of deferring taxes without the risks and problems (collecting rent, fixing leaks, property upkeep, etc.). DSTs can hold one or more properties.
However, and this is a big however, investors give up control of the management of the entity property and typically have limited liquidity, making it very difficult to cash out.
A 721 UPREIT has benefits over a DST because it generally offers more liquidity, but once you complete a 721 exchange, you can no longer continue exchanging. In addition, all money taken out of the UPREIT will be taxable going forward. A significant benefit of both a 721 UPREIT and DST is that they both allow for a step-up in basis for heirs. The heirs do not have to deal with depreciation recapture or long-term capital gains tax on the real estate.