Real estate investors are more familiar with the 1031 exchange, a like-kind exchange. This is where the owner exchanges their rental property for a new property at equal or greater value and can defer the taxes into the future.
It comes to a point when a real estate investor doesn’t want to be a landlord anymore, or they want to diversify their holdings and still defer their taxes. This is where a 721 exchange may be of interest.
The IRS code section 721 allows an investor to transfer property in exchange for shares in a Real Estate Investment Trust (REIT) without triggering the need to pay capital gain taxes. A REIT is like a mutual fund for real estate. It pools the capital of numerous investors. This makes it possible for investors to earn dividends from real estate investments without buying, managing, or financing the properties themselves.
Pros of a 721 Exchange:
- Tax deferral: Postponing your capital gains and state income taxes.
- Diversification: Instead of having all your cash tied up in a single property in a single town, you now own a fractional ownership in a multitude of properties that can vary in geography and property type. A REIT portfolio may include apartment complexes, data centers, healthcare facilities, hotels, office buildings, retail centers, self-storage, and warehouses.
- Liquidity: Many REITs are publicly traded, ensuring you can sell your shares if you need the cash.
- Passive Income: By law, REITs must pay a dividend of 90% of their taxable income to their shareholders.
- Appreciation: As with individual properties, the properties owned by the REIT can increase in value, which means your shares are worth more.
- Estate Planning: It is easier for your heirs to divide the shares of a REIT than it is to divide the interest in a single property.
Cons of a 721 Exchange:
- Market fluctuation: What goes up in value can also decrease. If your individual property can go down in value, so can properties owned in a REIT.
- Recognition of tax: The management of a REIT may decide it is time to sell one of its holdings. Instead of reinvesting the proceeds in a new building, management may distribute the money to the shareholders, which is taxable.
- Property Type: Not all properties will qualify for the 721 exchange.
Just like Section 1031, IRC Section 721 is complex, and investors should consult with a specialist in this field in coordination with their tax and legal advisors before making any investment decisions.
If you would like to discuss your business or personal tax planning, tax preparation, and other financial concerns with an experienced tax professional, we invite you to call 610-594-2601 today to make an appointment at our Exton, PA office to discuss your situation. You can also schedule a consultation at Click Here.
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About Bryan Haarlander, EA, CTRS:
Bryan Haarlander is an IRS-licensed Enrolled Agent and a Certified Tax Resolution Specialist who owns and operates a specialized tax services firm serving clients in the western suburbs of Philadelphia, PA. This includes the cities of Chester Springs, Coatesville, Collegeville, Devon, Downingtown, Exton, King of Prussia, Paoli, Philadelphia, Phoenixville, Pottstown, Radnor, Reading, Wayne, and West Chester. We also serve clients in Delaware, New Jersey, New York, and throughout the United States.
Bryan is well-known for his IRS tax resolution expertise and his book How to Resolve Your IRS Tax Debt Problems.
