721 vs 1031 Exchange

Understanding the Difference

Both 1031 and 721 exchanges offer tax-deferred solutions for real estate investors, but they serve fundamentally different investment objectives and life situations. Understanding these differences is crucial to selecting the strategy that best aligns with your investment goals, lifestyle preferences, and tax planning needs.

Feature	1031 Exchange	721 Exchange (UPREIT)
Legal Basis	Section 1031 of IRC	Section 721 of IRC
Transaction Type	Property-for-property swap	Property for partnership interests
Management Role	Remain active property owner	Become passive investor
Diversification	Single replacement property(s)	Interest in diverse property portfolio
Timeline Requirements	45 days to identify, 180 days to close	No strict timeline requirements
Debt Requirements	Equal or greater debt on replacement	Flexible debt arrangements
Liquidity Potential	Requires market timing	Cash or in-kind distribution
Ongoing Requirements	Continue property management responsibilities	No management responsibilities
Estate Planning	Physical property passes to heirs	Easily divisible securities for heirs

The 1031 Exchange: Property-for-Property

A 1031 exchange, named after Section 1031 of the Internal Revenue Code, allows investors to defer capital gains taxes by exchanging one investment property for another “like-kind” property. This strategy is ideal for investors who want to:

Remain active in real estate management
Upgrade to specific properties of their choosing
Consolidate or diversify their direct property holdings
Maintain complete control over their real estate investments

How a 1031 Exchange Works

Sell your investment property through a Qualified Intermediary who holds the proceeds
Identify replacement properties within 45 days of selling your property
Close on the replacement property within 180 days of selling your original property
Take title to the new property and continue as an active real estate investor

Advantages of a 1031 Exchange

Complete control over replacement property selection
Ability to leverage local market knowledge
Potential for hands-on value-add strategies
Can be repeated indefinitely throughout your lifetime
Step-up in basis for heirs upon death

Limitations of a 1031 Exchange

Strict timeline requirements create pressure
Finding a suitable replacement property
Continued landlord responsibilities
Lack of diversification (typically into one or few properties)
Replacement property must be equal or greater in value
Ongoing management and maintenance responsibilities

The 721 Exchange: Property-for-Partnership Interests

A 721 exchange, named after Section 721 of the Internal Revenue Code, allows investors to defer capital gains taxes by contributing investment property to a fund in exchange for ownership units. This strategy is ideal for investors who want to:

Transition from active management to passive ownership
Diversify across a broader portfolio of properties
Simplify their investment holdings and lifestyle
Begin the process of estate planning
Create potential liquidity options for the future

How a 721 Exchange Works

Contribute your property to a qualifying fund
Receive units proportional to your property’s net equity value
Transition to passive investor status with no management responsibilities
Receive regular distributions from the diversified property portfolio
Maintain tax deferral until units are sold or converted to REIT shares

Advantages of a 721 Exchange

No identification period or strict timelines
Immediate diversification across multiple properties
Professional management handles all property issues
No reinvestment pressure or loan qualification
Simplified tax reporting (single K-1 vs. multiple properties)
Potential liquidity path through receiving direct ownership of a specific property from the fund’s portfolio while potentially maintaining tax deferral benefits
Units can be easily divided among heirs for estate planning

Limitations of a 721 Exchange

Loss of direct control over property investment decisions
Reliance on management team’s performance
Potential restrictions on unit transfers or redemptions
Cannot specifically select the properties in the portfolio
May have less favorable loan terms at the portfolio level

Choosing Between 1031 and 721 Exchanges

The right strategy depends on your specific circumstances:

A 1031 exchange might be better if you:

Enjoy actively managing real estate
Have identified specific replacement properties
Want complete control over your investments
Are earlier in your investment career
Have the time and energy for ongoing property management

A 721 exchange might be better if you:

Want to simplify your life and reduce management responsibilities
Are planning for retirement or lifestyle changes
Need diversification across multiple properties
Are concerned about estate planning complexity
Want a potential path to liquidity in the future
Don’t want the pressure of finding replacement properties

Tax Considerations for Both Exchanges

Both strategies defer taxes rather than eliminating them. Key considerations:

Basis Carryover: Your tax basis carries over in both exchanges
Depreciation: Continues in both scenarios but is handled differently
Eventual Tax: Both defer taxes until a taxable event (sale for cash)
Estate Planning: Both can receive a stepped-up basis at death, eliminating deferred gain

The Hybrid Approach

Many investors take a phased approach to real estate. Early on, they use 1031 exchanges to grow their wealth by actively managing properties and increasing their value. Later in life—especially approaching retirement—they often shift to 721 exchanges, which let them keep real estate exposure but without the day-to-day hassles. This switch gives them passive income through fund units, and when passed on to heirs, those units may receive a stepped-up tax basis, potentially erasing the deferred capital gains taxes.

Some investors enjoy being hands-on at first, while others prefer to go passive right away so they can focus on their main business or career. For many—especially younger professionals—a 721 exchange offers a way to stay invested in real estate without spending time managing properties. The real question for young professionals is: where do you make the most money, and what do you enjoy doing? Choosing an investment strategy that fits both your financial goals and lifestyle usually leads to better outcomes over the long run.

Next Steps

If you’re considering a 721 exchange as your “final stop” for your existing property or need help with your next 1031 exchange, we’re here to assist. Contact us for a no-obligation consultation to explore how we can find a replacement property that fits your goals—and potentially the fund’s criteria—while keeping you on solid ground with the IRS.