A 721 exchange and a 1031 exchange are both tax-deferral strategies used in real estate transactions, but they serve different purposes and have distinct processes. Let’s dive into the details of each to understand their differences.

1031 Exchange

A 1031 exchange, named after Section 1031 of the Internal Revenue Code, allows real estate investors to defer capital gains taxes when they sell a property and reinvest the proceeds into a like-kind property. The key requirements for a 1031 exchange include:

• Like-Kind Property: The properties involved must be of like-kind, meaning they are both held for investment or business purposes. This is broadly interpreted for real estate, so most real estate properties qualify as like-kind to each other.
• Use of a Qualified Intermediary: To avoid constructive receipt of funds, the investor must use a qualified intermediary (QI) to facilitate the exchange. At Deferred.com, we offer qualified intermediary services to ensure compliance with IRS regulations. We handle the sale of the relinquished property and the purchase of the replacement property, holding the proceeds in between.
• Strict Timelines: The investor must identify potential replacement properties within 45 days of selling the relinquished property and must complete the purchase of the replacement property within 180 days.
• Reinvestment of Proceeds: To fully defer taxes, the investor must reinvest all proceeds from the sale into the replacement property and maintain or increase the level of debt.

Example of a 1031 Exchange

Imagine you own a rental property worth $500,000 with a mortgage of $200,000. You sell it and, through Deferred.com as your QI, you identify a new property worth $600,000 within 45 days. You use the $300,000 net proceeds as a down payment and take out a new mortgage for $300,000. By doing so, you meet the requirements of reinvesting all proceeds and replacing the debt, thus deferring the capital gains tax.

721 Exchange

A 721 exchange, on the other hand, involves the contribution of real estate to a Real Estate Investment Trust (REIT) in exchange for shares in the REIT. This type of exchange is governed by Section 721 of the Internal Revenue Code and is often used by investors looking to diversify their real estate holdings or gain liquidity without triggering a taxable event. Key aspects of a 721 exchange include:

• Contribution to a REIT: Instead of exchanging one property for another, the investor contributes their property to a REIT and receives operating partnership units (OP units) in return. These OP units can later be converted into REIT shares.
• Tax Deferral: The exchange of property for OP units is generally tax-deferred, meaning the investor does not recognize a gain at the time of the exchange.
• Liquidity and Diversification: By converting real estate into REIT shares, investors gain liquidity and can diversify their investment across a portfolio of properties managed by the REIT.
• No Like-Kind Requirement: Unlike a 1031 exchange, a 721 exchange does not require the properties to be like-kind, as the transaction involves exchanging real estate for securities.

Example of a 721 Exchange

Suppose you own a commercial property valued at $1 million. You decide to contribute this property to a REIT. In return, you receive OP units equivalent to the value of your property. These units can later be converted into REIT shares, providing you with liquidity and diversification. The transaction is tax-deferred, allowing you to defer capital gains taxes until you sell the REIT shares.

Both 1031 and 721 exchanges offer valuable tax-deferral opportunities, but they cater to different investor goals. A 1031 exchange is ideal for those looking to continue direct real estate investment, while a 721 exchange suits those seeking liquidity and diversification through REITs. At Deferred.com, we specialize in facilitating 1031 exchanges, ensuring a smooth and compliant process for our clients.