Video: Dynamics of the 721 Exchange
Greg Mausz, chief operating officer at Preferred Capital Securities, and Mark Kosanke, the founding partner of Concorde Financial, discuss 721 exchanges in the latest video from ADISA’s Focus on Alternatives, an educational series that covers key topics in alternative investing,
The lesser known 721 exchange allows a real estate investor to defer paying capital gains taxes on a property disposition in exchange for operating partnership units in a real estate investment trust, or umbrella partnership REIT (UPREIT).
Kosanke explains the history of 721 exchanges and their potential tax and diversification benefits, how the structure differs from a 1031 exchange, potential disadvantages, and the key factors that an advisor and investor should look for when considering such an investment.
Video Transcript
Greg Mausz  00:06
Welcome to another edition of Focus on Alternatives brought to you by ADISA, the Alternative and Direct Investment Securities Association. For more educational content like this please check out the resource library at adisa.org. My name is Greg Mausz, and today I’m joined by Mark Kosanke who’s the founding partner of Concord Financial. And we’re gonna be talking about all the different dynamics of the 721 Exchange. Um Mark, can we start off by what is the 721 Exchange? I’ve… I know 1035 for annuities, I know 1031 for properties but what’s the 721?
Mark Kosanke  00:43
So, a 721 exchange goes back to a REIT structure… the REIT structure goes back to the Eisenhower administration when REITs or real estate investment trusts they’re actually created as a way of holding real estate. Section 721 actually stands for the code section of the IRS which allows you to take a piece of property and put it inside of that REIT or UPREIT it and in exchange for operating partnerships in the read itself. So, it’s a way of getting out of real estate management but putting it into a reach structure and the transaction is completely taxed deferred. So, I’m getting rid of my property I’m putting it into a different structure and I’m not incurring a capital gains on that transaction.
Greg Mausz  01:30
OK, that makes sense, can you expound on that and maybe explain more how it’s different from the 1031 exchange.
Mark Kosanke  01:36
Sure, in a 1031 exchange I’m exchanging real estate for real estate. So, if I sell my piece of property I have to buy another piece of property or several pieces of property and it’s kind of like an IRA rollover. I’m rolling roller from one piece of real estate to another it’s completely text deferred, that’s the traditional 1031 exchange. I can then do that for the rest of my life, I can swap to your drop. I can exchange, exchange, exchange as long as I want. 721, I’m putting the property into an operating partnership once I do that, I lose my ability to 1031 exchange going forward. So, while both transactions allow for tax deferral one transaction allows you to keep doing that and the other one, I’ve kind of given up my control of doing that exchange going forward.
Greg Mausz  02:25
That makes sense, so if an investor is going to deliberately go out and pursue a 721 strategy what are the main advantages to that?
Mark Kosanke  02:34
Well, the advantages… typically I’m owning one… two pieces of property. And if I do an exchange, I’m going to own one or two pieces of property. When I exchange into a 721 whether it’s a non-traded REIT, a public REIT, a private REIT I am REITs typically are going to own dozens and sometimes hundreds of properties. So, I have diversified myself from one or two properties to maybe in some cases several hundred. So, diversification is a big reason why you would do a 721 exchange.
The REIT is also going to produce income and that income now is dependent on all those properties not just one. So again, I’m getting I’m getting that diversification. And then it’s a different exit strategy, when I own the operating units of a 721 UPREIT I can sell all of them part of them so I have a little more control over my exit strategy as opposed to well if I own this piece of property, I can’t sell 5% of it I’m selling the whole thing. so, it does give me a little bit of an exit strategy when doing that. And then a lot of families will use it for estate planning purposes as well.
Greg Mausz  03:44
Expound on that more what do you mean by estate planning purposes?
Mark Kosanke  03:49
Well, the whole idea is to defer your taxes today and if you plan it right never pay the taxes. So, on a 1031 exchange we call it swap to your drop. In a situation where we’re doing a 721 UPREIT, the idea is that we’ve done this tax deferred exchange into the 721 and under the current tax rules you get stepped up in basis upon death. So, what you’re actually looking for is to hold that operating partnership until the death of the owner, now the family the beneficiaries get stepped up basis and the tax goes poof on the owner’s last breath. So, both of them accomplished that step up in basis at the end it’s just a matter of It’s two different paths to get there.
Greg Mausz  04:34
Thank you for walking us through those advantages. Any downsides?
Mark Kosanke  04:38
Well, the downside is I do lose control. I don’t have control of doing those 1031s going forward anymore. So, I am kind of giving up I am kind of giving up that piece. I have no voting rights in the REIT either, so the REIT would be buying and selling properties may even liquidate at some point, I don’t have any control over that.
The other thing you have to look at is while I’m going into a reach structure that may own dozens or hundreds of properties, I got to look at what those properties are. What kind of REIT am I going into? Who’s running it? What’s its track record? what’s its leverage? There are all kinds of things you need to look at from the standpoint of you know what could be some of the disadvantages. The biggest disadvantage for most of our investors would be you lose the ability to 1031 going forward.
Greg Mausz  05:24
So as an investor is weighing the options here, what are the key factors that an advisor and investor should look at in deciding to pursue a 721 transaction?
Mark Kosanke  05:37
Well, I think you know again you have to look at the options. In some cases, a 721 can save a property. Let’s say a property needs to be capitalize or leverage which you cannot do in a DST or may be difficult to do on your own in a 1031 transaction. By putting it into a 721 the REIT would have the opportunity to maybe correct the property, leverage it, do some capital improvements where you can’t do that in some of the other structures so that’s certainly a consideration.
You may be saving yourself by doing the 721. You know again I think you’ve got to look at what’s your estate planning purpose? Do I want to be able to get out of this all at once or do I want to be able to step out of it maybe selling pieces of my operating property or operating partnerships as opposed to selling it all at once. So, I think you’ve really got to (clears throat) excuse me, I think you really need to look at what is the ultimate goal of the exchanger and do these you know these factors that play into the 721 really work for your estate planning.
Greg Mausz  06:42
Right, that makes a lot of sense. And you know you get the income from the real estate but to your point if someone is trying to do income planning in their later years the fact that they can sell off piece’s um of the operating partnership and take that in as income uh could be very powerful tool.
Mark Kosanke  07:01
Yeah, that’s it is very powerful tool because if I obviously sell my property, I’m paying tax on it all today. If I go into the operating partnership of 721, I may be able to say sell 10% a year over a course of time and spread that tax and again spread that risk I spread the tax I still create income and I have the ability I guess to do a little more orderly exit strategy as opposed to waiting until somebody dies.
Greg Mausz  07:29
Right, Mark thank you for walking us through the dynamics of the 721 transaction.
Mark Kosanke  07:34
You’re welcome, my pleasure.
Greg Mausz  07:35
And thank you for watching another episode of Focus on Alternatives. For more content like this please visit adisa.org. Thank you.
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