The Best Kept Secret (721 Exchange)
The Best Kept Secret in Real Estate Investing
by Nate Higgins, M.S., MBA
Almost every real estate investor has heard of a 1031 Exchange - a provision in the US tax code that allows for the deferral of capital gains on the sale of real estate when it is exchanged for a like-kind property. While the 1031 Exchange is a wonderful tool for the active real estate investor looking to build their portfolio, it does have it’s drawbacks. Among them, the investor is under tremendous pressure from a time perspective. The investor must identify a like-kind property in 45 days and close on that property in 180 days. Additionally, if one is looking to scale back from their active real estate holdings, a 1031 Exchange is less than ideal.
You may love real estate as an asset class, but simply don’t have the desire to manage it anymore. You’d like to sell, but over the years you have steadily depreciated the property to the point that the basis is significantly lower than what you paid for the property, while the property itself has appreciated substantially. In other words, if you were to sell today you’d have a sizeable capital gain liability. Enter the 721 Exchange.
A 721 Exchange involves exchanging the property for the shares of a Real Estate Investment Trust (REIT). Where this is advantageous for the property owner:
- Allows the property owner to transfer their real estate exposure from active to passive (i.e. no more headaches from managing tenants or vendors)
- The owner retains exposure to real estate as an asset class in the form of institutional grade real estate
- Receives truly passive income in the form of a quarterly dividend (which they can also elect to reinvest to buy additional shares)
- Unlock the equity in their property without having to refinance or pay capital gains from a traditional sale
- The transaction itself is a low to no fee transaction (aside from traditional brokerage and transaction fees)
- Shares are liquid and can allow the owner to sell a few shares at a time
Disadvantages of a 721 Exchange:
- Property can only be exchanged for shares of the REIT
- Control of the REITs properties is not in the hands of the shareholder
- Property must be in an LLC in order for the 721 Exchange to be initiated
At this point, you’re probably wondering, what is a REIT? A Real Estate Investment Trust (REIT) is a company that owns income-producing real estate. Modeled after mutual funds, REITs provide investors the opportunity to own real estate and the opportunity to access dividend-based income and along with the asset appreciation. REITs lease space and collect rent on the real estate they own. This could be a wide variety of asset classes, including: apartments, medical office, vacation rentals, and industrial. The company generates income which is then paid out to shareholders in the form of a dividend. REITs must pay out at least 90 percent of their taxable income to shareholders.
No capital gains deferral strategy is a magic bullet that will suit every situation. However, there are alternatives available outside of a 1031 Exchange that will empower the real estate investor to defer capital gains while attaining passive, tax-advantaged exposure to real estate as an asset class. Call Equilus Capital Partners to learn more: 509-665-88349.