From a Single, Vulnerable Property to a Diversified Portfolio: Why the 721 Exchange Is the New Upgrade in Real Estate Investment

Anyone who thinks owning rental property is an easy road to riches should spend a little time with a landlord. From managing tenant relations and coordinating short- and long-term maintenance and repairs to worrying about nearby vacancy rates—it adds up to what can be a very lucrative business that’s in no way easy.

This is also why many investment property owners regularly review their portfolios as they near retirement to see if they’re meeting their expected needs. This is a time when some choose to sell properties to help fund retirement and other life goals. And others decide they want to keep the tax advantages and income provided by real estate, but they’re not interested in the day-to-day drudgery of land lording. What are their options?

Expanding Your Choices with a 1031 Exchange, and More

The 1031 exchange is one of the most valuable tools investors can use. It allows them to effectively trade one property for another of equal or greater value and defer capital gains on any profit from the sale.

However, there are situations where investors find they need to do more than simply swap properties in and out of their portfolio. Individuals may see that their holdings are concentrated in a particular area, making them vulnerable to disasters or local economic upheaval. They might want to ease their loved ones’ burden by setting up a simpler portfolio in case of their incapacitation, or they could be looking for an uncomplicated way to stay invested in real estate without being so hands-on. Fortunately, there are two solutions investors can use that address these issues and simplify their portfolios.

The 721 exchange, also known as an umbrella partnership real estate investment trust (UPREIT) and the Delaware Statutory Trust (DST) are recognized as two efficient methods of conducting a 1031 exchange. Both are designed to fit into the needs of most real estate investors, but there are key differences (see the comparison matrix) that may help you decide on one over the other.

They also help alleviate a big headache for people doing a 1031 exchange: the countdown clock. Once an investor closes on the sale of their rental property, the 45-day clock begins during which time they must identify potential replacement properties that would replace the sold asset in their portfolio. And on the same day, a 180-day clock begins to count down on the closing of a replacement property(ies). These are calendar days, not business days, and in general they are not extendable.

For investors who haven’t researched enough into exchange opportunities, these can be tough deadlines and can tarnish a profitable sale due to capital gains taxes. This is why many look to both DSTs and 721 UPREITs as “standby investments.” If they’re unable to find transferable property that suits them, they can invest in one to ensure they defer the capital gains taxes before the deadline.

721 vs. DST

While similar, there are some subtle differences in both solutions that investors should be aware of. The typical DST gives investors a fractional ownership of one or a small number of properties held by the trust. The ownership shares are legally considered securities, and most are limited to 499 owners to avoid the additional SEC paperwork that comes with 500 or more investors.

“A key difference is that in a DST you’re still considered to have direct ownership of a piece of real estate,” says Dwight Dunton, founder, CEO, and CIO of Bonaventure, an integrated alternative asset management firm based in Alexandria, Virginia. “This gives you some of the same tax benefits you had when you owned an individual property, like depreciation.”

A 721 UPREIT could be described as a DST with a little more flexibility. Investors trade their property for operating partnership (OP) units in an underlying REIT that owns a group of diverse properties. UPREIT investors are completely passive, and their only interaction with the entity can be when income distributions show up in their account. “In addition, holding OPs makes estate planning easier, since they’re easily divided among heirs and are more liquid than fractional shares in a DST,” says Dunton.

Choosing between the two solutions may seem a little like splitting hairs because of the similarities, but many investors find 721s to be more adaptable to their needs.

Think of the 721 As an Upgrade: A Better 1031 Exit for Investors

For one thing, investors looking for an exit that takes them out of property management headaches but still gives them the income they need find participating in a UPREIT a refreshing change. There’s also the end of existential worries that come with a portfolio that lacks geographic and category diversity, since UPREITs balance risk by owning multiple properties in different areas.

Another advantage of a 721 is that it’s generally more liquid than other types of real estate investments. In a publicly traded REIT owners can trade their OPs after a period of time for REIT shares that can be sold on the stock market. With private REITs there are agreements that after an initial holding period owners can begin redeeming their OPs for cash. This is also often an important consideration in estate planning since not all of one’s heirs may be interested in keeping their shares in real estate.

If one doesn’t have a property that would interest a UPREIT for a 1031 exchange, there is another method to investing in one. The individual first does a 1031 exchange with a DST, then after a waiting period, the fractional shares in the DST property(ies) are exchanged for OPs in a 721 exchange.

The inherent advantages make it clear that if you find you’re looking for reduced portfolio risk, greater liquidity along with a reduced workload, the 721 exchange is worth a long, hard look.