harrison 
For real estate investors looking to defer capital gains taxes while continuing to build their portfolios, the Internal Revenue Code offers two powerful strategies: the 1031 exchange and the 721 exchange. Both allow for tax deferral, but they serve different purposes and are suited to different stages in an investor’s journey.
Understanding the differences between these two exchanges can help investors make smarter decisions about their assets, especially when transitioning from hands-on property ownership to more passive, diversified real estate investments.
The 1031 exchange, governed by Section 1031 of the Internal Revenue Code, allows an investor to sell one investment property and reinvest the proceeds into another like-kind property, while deferring capital gains taxes on the sale. This is one of the most widely used tax-deferral tools in real estate and is particularly attractive to investors who want to continue owning and managing real property.
To qualify, the property sold must be held for investment or business use, and the replacement property must also be of like kind, used for investment or business purposes. The investor must identify the replacement property within 45 days and close on it within 180 days. As long as these rules are followed, capital gains taxes from the sale of the original property can be deferred indefinitely.
The 1031 exchange is popular because it allows investors to upgrade to higher-value properties, consolidate several properties into one, or diversify into different property types or markets. It’s also a powerful estate planning tool since heirs can receive a stepped-up cost basis upon inheritance, effectively eliminating the deferred capital gains.
A 721 exchange, on the other hand, is less commonly known but serves a different type of investor need. This exchange is outlined under Section 721 of the Internal Revenue Code and allows an investor to contribute property to a real estate investment trust (REIT) or its operating partnership in exchange for ownership units, often called operating partnership units or OP units. The key distinction is that the investor no longer owns the property directly. Instead, they hold units in a diversified real estate portfolio managed by professionals.
When an investor contributes property to a REIT’s operating partnership through a 721 exchange, no capital gains tax is triggered at the time of the contribution. Over time, these OP units may be converted into shares of the REIT and potentially sold on the public market, at which point taxes are due.
The main advantage of a 721 exchange is the shift from active property management to passive income generation. Investors gain exposure to a larger, diversified portfolio of income-generating properties without the headaches of managing tenants, maintenance, or compliance. This is especially attractive to older investors who are planning for retirement or those looking to simplify their financial lives.
One of the key differences between the two strategies lies in what the investor receives in return. In a 1031 exchange, the investor trades one physical property for another. They remain a direct owner of real estate and are responsible for its management. In a 721 exchange, the investor gives up direct ownership of property and receives operating partnership units, which represent a stake in a professionally managed portfolio.
Another major difference is control. A 1031 exchange allows the investor to choose the replacement property and continue making decisions about leasing, improvements, financing, and management. In a 721 exchange, control is ceded to the REIT, and the investor has no influence over the operation of the underlying assets. This lack of control can be a drawback for some, but for others, it’s a welcomed relief.
Liquidity and diversification are also different between the two options. With a 721 exchange, investors may eventually convert their OP units into REIT shares, which can be sold on the open market, providing liquidity not typically found in traditional real estate. In addition, REITs own a wide array of properties, giving investors exposure to different geographic regions and asset types. This level of diversification is one of the appeals of UPREITS, which are REIT structures that accept property contributions through 721 exchanges.
On the flip side, not all properties qualify for a 721 exchange. The REIT must be interested in acquiring the property, and it must fit into the REIT’s investment strategy. This means that investors can’t assume any property will be accepted. In contrast, 1031 exchanges offer more flexibility, since the replacement property can be selected from a much broader pool of opportunities.
There are also estate planning considerations. With a 1031 exchange, the property can be passed on to heirs with a stepped-up basis, eliminating deferred taxes. In a 721 exchange, OP units can also be inherited, and a similar step-up in basis may apply. However, the conversion of OP units to REIT shares and subsequent sale may trigger taxes, so timing and structure matter.
Deciding between a 1031 and a 721 exchange comes down to the investor’s goals. If you want to stay actively involved in real estate, continue building your portfolio, and defer taxes while maintaining control, a 1031 exchange is likely the better choice. If you’re looking for a way to step back from day-to-day management, gain access to professionally managed, institutional-grade properties, and still defer taxes, a 721 exchange may be the ideal solution.
Some investors actually use both strategies in a combined approach. For instance, they might complete a 1031 exchange into a Delaware Statutory Trust (DST), and later, when the DST is sold to a REIT, the investor can then participate in a 721 exchange. This layered strategy offers flexibility and a gradual transition from active to passive investing.
Regardless of the path you choose, working with experienced tax advisors, legal counsel, and qualified intermediaries is critical. Both 1031 and 721 exchanges come with complex rules, strict timelines, and long-term implications. With the right guidance, investors can use these tools to defer taxes, build wealth, and align their portfolios with their lifestyle and retirement goals.
In conclusion, while both the 1031 and 721 exchanges offer valuable ways to defer capital gains, they are designed for different types of investors and investment strategies. The 1031 exchange is best suited for those who want to stay in control of their real estate investments, while the 721 exchange is ideal for investors ready to transition into a more passive and diversified structure through a REIT. Understanding the differences between the two can help you make informed decisions that serve both your financial and personal goals.
