Investing in real estate can be a lucrative venture, offering opportunities for diversification and potential tax advantages. However, not all real estate investment strategies are created equal, and some come with hidden tax traps that investors need to be aware of. One such trap is the 721 UPREIT transaction, which can have unforeseen tax consequences for unwary investors. In this blog post, we'll delve into what a 721 UPREIT is, why it can be a tax trap, and how investors can protect themselves.

Understanding the 721 UPREIT Transaction

In a typical 721 UPREIT transaction, an investor sells their property and performs a 1031 exchange, purchasing ownership in a Delaware Statutory Trust as their replacement property. If the DST includes the 721 UPREIT exit strategy, it means that the DST sponsor may then choose to have their REIT (Real Estate Investment Trust) purchase the DST property.  The potential benefit to the DST investors is the ability to trade in their ownership interests in the DST for operating partnership (OP) units in the sponsor’s REIT. These OP units are later converted into shares of the REIT. The rationale behind this transaction is typically to achieve greater diversification and liquidity, as well as potential for continued tax benefits.

The Tax Trap Unveiled

The trouble with 721 UPREIT transactions arises when the conversion of OP units into REIT shares triggers a taxable event for the investor. This means that even though the investor hasn't received any cash proceeds, they are still liable for taxes on any gains realized from the conversion. Moreover, if the market experiences volatility or the REIT underperforms, the value of the REIT shares received by the investor may decrease, compounding the tax implications of the transaction.

Example Scenario

Let's illustrate this with an example: Investor A decides to exchange their ownership interest in a DST for OP units in a REIT through a 721 UPREIT transaction. Subsequently, the OP units are converted into REIT shares. However, due to market fluctuations, the value of the REIT shares declines. As a result, Investor A's capital account is lower, but they still owe taxes on any gains realized from the transaction based on the original basis of the DST investment. The tax liability is unchanged by the drop in value of the investment.

Mitigating the Risks

So, how can investors mitigate the risks associated with 721 UPREIT transactions? One crucial factor to consider is the reputation and performance of the REIT that will be acquiring the DST. Investors should conduct thorough due diligence to assess the REIT's track record, financial health, and potential for future growth. Additionally, consulting with tax professionals and financial advisors can provide valuable insights into the tax implications of such transactions and help investors make informed decisions.

Conclusion

While 721 UPREIT transactions offer the potential for diversification and liquidity, they also come with significant tax risks that investors need to be mindful of. By understanding the mechanics of these transactions and conducting proper due diligence, investors can mitigate the risks and make more informed investment choices. Remember, not all REITs are created equal, so choose wisely to avoid falling into the tax trap of 721 UPREITs.

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*Past performance is no guarantee of future results. *Diversification does not guarantee returns and does not protect against loss. *Preferred return is not guaranteed and is subject to available cash flow. *These examples are the experiences of a few of our clients and may not represent the experience of others. *These testimonials may not be representative of the experience of other clients. These clients were not compensated for their testimonials. Please speak with your attorney and CPA before considering an investment. *All DST properties shown are Regulation D Rule 506(c) offerings. All Offerings are subject to availability. There can be no assurance that any DST properties and offerings will be available for purchase. *DST 1031 properties are only available to accredited investors (generally described as having a net worth of over $1 million exclusive of primary residence, and/or possessing an annual income of over $200,000, or $300,000 with a spouse and expects the same or greater for the current year) and accredited entities (generally described as an entity owned entirely by accredited investors and/or owning investments in excess of $5 million). Please check with a qualified CPA or attorney to determine if you are accredited.

This material does not constitute an offer to sell nor a solicitation of an offer to buy any security. Such offers can be made only by the confidential Private Placement Memorandum (the “Memorandum”). Please read the entire Memorandum paying special attention to the risk section prior investing.  IRC Section 1031, IRC Section 1033 and IRC Section 721 are complex tax codes therefore you should consult your tax or legal professional for details regarding your situation.  There are material risks associated with investing in real estate securities including illiquidity, vacancies, general market conditions and competition, lack of operating history, interest rate risks, general risks of owning/operating commercial and multifamily properties, financing risks, potential adverse tax consequences, general economic risks, development risks and long hold periods. There is a risk of loss of the entire investment principal. Past performance is not a guarantee of future results. Potential cash flow, potential returns and potential appreciation are not guaranteed.