Consider a landlord who’s built a substantial portfolio over many years — leasing, managing, and growing it into a source of real, ongoing income. Eventually, the time comes to think about retirement. For many landlords in that position, the tax bite on a sale can be steep: watching the IRS take 15-20% off the top in one transaction can feel like years of patient work getting skimmed at the finish line.
On the other side of that trade are younger investors looking to get into real estate, ready to buy — which raises the question for the seller: where does the money go next, and how do you avoid the tax hit? Aside from the classic 1031 exchange, which has its own downsides and limits, what other options exist to reduce hands-on work without losing a chunk of the proceeds to taxes?
Consider a 721 Exchange
The 721 exchange, often called a Section 721 Exchange or 721 UPREIT (Umbrella Partnership Real Estate Investment Trust) exchange, is a tax deferral strategy for real estate investors. It’s less commonly discussed than the 1031 exchange, but it offers unique benefits — especially for investors looking to diversify their real estate holdings without triggering an immediate tax bill.
What Is a 721 Exchange?
A 721 exchange is a provision under Section 721 of the Internal Revenue Code that allows real estate investors to defer capital gains taxes by contributing property to an UPREIT in exchange for Operating Partnership (OP) units. Unlike a 1031 exchange, where one property is swapped for another, a 721 exchange involves contributing a property to an UPREIT — a structure built around a real estate investment trust (REIT).
In essence, the investor trades direct ownership of real estate for an ownership interest in a portfolio of properties managed by the UPREIT. The OP units received can later be converted into REIT shares or cashed out, though that conversion may trigger capital gains taxes at that point.
How Does the 721 Exchange Work?
- Identify a suitable UPREIT. The first step is finding an UPREIT interested in acquiring your property. UPREITs typically target large, income-generating properties such as commercial real estate, apartment complexes, or office buildings.
- The two-step, when needed. More often, an investor’s property isn’t a fit for a given REIT directly. The workaround: first complete a 1031 exchange into a Delaware Statutory Trust (DST) — a structure that offers fractional ownership in one or several large properties, providing diversification and passive investment, though it can be fairly illiquid. Then, complete a 721 exchange from the DST into the UPREIT’s operating partnership, which can later be converted into shares and sold — including in fractions, which limits how much tax is triggered at once and provides income as it’s needed, while still preserving passive income and diversification with more liquidity for redemption.
- Conversion to REIT shares. At a future date, the investor can convert OP units into REIT shares. This may trigger capital gains taxes, but it also offers increased liquidity, since REIT shares can be sold on the stock market.
Benefits of the UPREIT Structure
- Deferred taxes — the primary benefit of a 721 exchange. The investor’s tax basis in the property carries over to the OP units received, deferring tax liability until those units are converted into REIT shares or sold for cash.
- Diversification — instead of owning a single property, the investor holds an interest in a diversified portfolio managed by the UPREIT, reducing single-asset risk and adding flexibility.
- Professional management — the UPREIT structure involves professional management of the real estate portfolio, relieving investors of day-to-day property management responsibilities.
Risks to Consider
- Tax implications — the initial exchange is tax-deferred, but eventual conversion to REIT shares or sale of OP units may trigger capital gains taxes, so investors need to plan their exit strategy carefully.
- Limited exit options — once real estate is exchanged into an UPREIT, there’s no going back or further exchange; the only exit is selling REIT shares and paying the tax. For heirs receiving a step-up in basis, this can actually be an easier exit than selling individual real estate.
- Less control — investors relinquish direct control over the property. This reduces management responsibilities, but it also means less say in how the underlying assets are operated.
The Bottom Line
A 721 exchange represents a compelling option for real estate investors seeking to diversify their holdings, defer taxes, and gain liquidity. By contributing a property to an UPREIT in exchange for OP units, investors can move from direct property ownership to a diversified, professionally managed portfolio. As with any investment strategy, it requires careful consideration of the potential risks and benefits — and a conversation with tax and financial professionals to determine whether it fits your long-term goals.
