Sponsored: What the Future of 721 UPREIT Products Means for Real Estate Investing

By: Edward Fernandez, President and CEO, 1031 Crowdfunding

By: Edward Fernandez, President and CEO, 1031 Crowdfunding

During his presidential campaign in 2020, then-candidate Joe Biden indicated that he’d pursue eliminating 1031 exchanges to help generate additional tax revenue for the government.

This was not the first time 1031 exchanges had been threatened, as the Obama administration targeted them for potential elimination as well, but with no eventual action taken. The recently passed Inflation Reduction Act made no changes to Section 1031 of the U.S. Internal Revenue Code, offering at least a temporary reprieve for 1031 exchanges.

However, the continued targeting of 1031s has generated considerable interest in another product — the 721 UPREIT, an umbrella partnership-style real estate investment trust. An UPREIT is a distinctive REIT structure that enables someone to exchange property they own for share ownership in the UPREIT. Property-for-share exchanges in an UPREIT are typically allowed under Section 721 of the Internal Revenue Code.

I take an acute interest in these developments as the president and CEO of 1031 Crowdfunding, a leading real estate investment platform for 1031 exchanges and alternative investment vehicles focused on tax deferral. On our platform and others, the Delaware Statutory Trust has traditionally offered a popular way to execute a 1031 exchange.

But as UPREITs gain momentum, we’re starting to see many DST products come out with the 721 option. The reasoning makes sense. When sponsors try to raise equity with discretionary investors — those who are interested in investing but don’t really have to — it’s much harder than with people who feel a sense of urgency to invest because of their desire to avoid taxes.

In creating a 721 UPREIT eligible product, you get the best of both worlds — attracting each type of investor. If you can accumulate and retain assets under management much faster than just doing one or the other, why not combine the two?

Future of 1031 Exchanges

Back to the topic of 1031 exchanges, I personally don’t think they’ll ever be eliminated — at least not for long — for a couple of reasons. First, 1031s touch so many professions that to do away with them would impact over 560,000 jobs. From real estate brokers to qualified intermediaries, along with escrow, title, appraisal and third-party report companies, there are so many livelihoods that hinge on or are instrumental to the 1031 exchange process. Putting all of those people out of work would create a much bigger problem for the economy than whatever it is someone thinks they’d be solving.

Second, the rationale behind eliminating 1031 exchanges is based on an erroneous assumption — that investors will continue to sell their properties anyway and pay the resulting taxes. The reality is that property owners aren’t obligated to sell anything. And savvy investors understand that if 1031s are banned based on a particular presidential administration’s agenda, they probably just need to wait it out. This is because stifled activity in the real estate industry caused by people not selling properties will likely raise a clamor to change the rules again and bring 1031 exchanges back.

Rise of 721 UPREITs

That said, since eliminating 1031 exchanges remains a topic of political discussion, it behooves sponsors to explore other options in order to protect their businesses. Based on the threat posed at the time by the incoming Biden administration, sponsors began to create 721 UPREIT products — which enable investors to still defer taxes on sale of real property, but in a different format.

What does this changing environment mean for real estate investing? There are two components to that question: investors and sponsors. On the investor side, I don’t see DSTs going away anytime soon. Even though being passive isn’t attractive for all investors, the DST will always offer appeal because it provides certainty of closing, institutional-quality real estate and third-party management of that asset, along with portfolio diversification and tax mitigation via a 1031 exchange.

On the sponsor side, the DST is essentially a mechanism to acquire an investor. Once that happens, a sponsor’s goal is always to keep the investor, and the 721 UPREIT now offers the best way to do that. Why? Because most of the time, if an investor just invests in the DST and it goes full cycle, the investor would have the option to do a 1031 exchange in another DST managed by the sponsor — but that doesn’t necessarily mean they will. The investor might decide to buy their own property instead, meaning the sponsor would lose that equity.

With a 721 component, the sponsor discloses to an investor that they’re going into a DST and when that DST sells, it will be sold into the sponsor’s REIT. As a result, the sponsor can feel confident about keeping the client and accompanying equity. The other reason many sponsors are aggregating portfolios is because they generally don’t make a lot of money in the DST despite taking on great risk. But if a sponsor creates a REIT and DSTs, those DSTs essentially become “REIT food,” substantially increasing the value of the REIT and generating significant revenue streams.

Additionally, without the DST component, individual investors would find it challenging to accomplish a pure 721 exchange, where the investor directly contributes their property in exchange for ownership in the REIT. In this situation, the investor would need to find a REIT interested in taking on their property. These types of transactions are rare because the REIT is generally not interested in the real estate offered by the investor unless it perfectly fits within their acquisition criteria and underwriting model.

Amid all the articles about potential elimination of 1031s, you never read about the possibility of the IRS doing away with 721 UPREITs, which also make them appealing to sponsors. However, the 721 process has operated largely under the radar so far. If 1031s are ever eliminated and 721s become the new high-profile way of deferring taxes through real estate investing, they could become a target as well. But that’s a scenario to address another day.

1031 Crowdfunding is a sponsor of The DI Wire, and this article was published as part of their standard directory sponsorship package. The views and opinions expressed are those of the author and do not necessarily reflect the views of The DI Wire.

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