Tax Smart Real Estate Investors Podcast, Episode 235: Unlocking the Secrets of the "721 Exchange"

Release Date: August 22, 2023

In Episode 235 of the Tax Smart Real Estate Investors Podcast, hosted by Tom from Hall CPA, listeners are introduced to the intricate world of Section 721 exchanges—a sophisticated yet often overlooked real estate exit strategy. This episode serves as a comprehensive two-part discussion featuring Caitlin Deaver, Tax Manager and Head of Hall CPA’s Private Equity Division, and Keith Nelson, Managing Partner of Dual City Investments, a firm that excels in executing 721 exchanges.

1. Introduction to Section 721 Exchange

Tom sets the stage by framing the 721 exchange as an alternative to the more commonly known 1031 exchange. He explains that while a 1031 exchange allows for the deferral of capital gains taxes by swapping one property for another, the 721 exchange facilitates the contribution of property to a partnership in return for partnership interests, also deferring tax liabilities.

Tom [00:29]: "A 721 exchange allows you to basically contribute your property to a partnership in exchange for a partnership interest without having to incur a tax event."

2. Understanding Section 721 Exchange

Caitlin Deaver delves into the specifics of Section 721, quoting the Internal Revenue Code to ground the discussion.

Caitlin Deaver [02:06]: "Section 721 says no gain or loss shall be recognized to a partnership or to any of its partners in the case of a contribution of property to the partnership in exchange for an interest in the partnership."

She clarifies that unlike a 1031 exchange, which is property-for-property, a 721 exchange involves property for an interest in a partnership, providing flexibility for investors who wish to shift their holdings into a partnership structure without immediate tax consequences.

3. Tax Implications and Capital Gains

The conversation transitions to the tax deferral benefits of a 721 exchange. Caitlin explains that while the immediate capital gains are deferred, they are not forgiven. The deferred gains become relevant when the partnership eventually sells the property or when the investor exits the partnership.

Caitlin Deaver [04:54]: "There's some nuances. When you contribute property to a partnership, what we do is called 4C built in gain. So if I contributed this for partnership and it's appreciated, then that first portion of the gain that I had already generated... is first going to be allocated to me."

Tom summarizes the essence of deferring capital gains through this strategy:

Tom [05:40]: "It's an exit strategy, it's a deferral strategy, it's a diversification strategy, and it's in many ways an alternative to say a 1031 exchange or a Delaware statutory trust DST."

4. Debt and Section 721 Exchange

Addressing the complexities of encumbered properties, Caitlin emphasizes the importance of understanding how existing debts on a property influence the exchange. She warns that if the debt exceeds the property's basis, it could trigger capital gains recognition, making professional guidance essential.

Caitlin Deaver [06:49]: "If you had a $100,000 loan on a $50,000 property, then we do start talking about having to recognize gain on this transaction."

A crucial disclaimer is provided to underscore the complexity of 721 exchanges, urging listeners to consult legal and tax professionals before proceeding.

5. Practical Applications: Aligning Property Types

Tom highlights a practical scenario where an investor might need to align their property type with the fund's requirements. He explains that if an investor's property doesn't match the fund's focus, a two-step process involving a 1031 exchange to a compatible property followed by a 721 exchange might be necessary.

Tom [10:31]: "...you might have to take advantage and do a 1031 before you consider a 721 exchange."

Caitlin supports this by sharing a real-life example of a single-family home fund accepting properties only matching their portfolio criteria, demonstrating the strategic alignment required for successful exchanges.

6. Cost-Benefit Analysis

A critical consideration discussed is the cost-benefit analysis of executing a 721 exchange compared to other strategies like 1031 exchanges or Delaware Statutory Trusts (DSTs). Tom advises evaluating the costs associated with intermediaries, legal advice, and additional tax preparation against the tax deferral benefits.

Tom [10:31]: "Consider the cost benefit analysis here... it's up to you and the fund manager that you're working with to determine and to just do a cost benefit analysis."

7. Dual City Investments and 721 Exchange Strategy

In the second segment, Keith Nelson introduces Dual City Investments’ approach to 721 exchanges. He explains how his firm facilitates these exchanges by accepting properties into their fund in exchange for partnership interests, enabling investors to defer capital gains taxes while diversifying their real estate portfolios.

Keith Nelson [13:48]: "We can take in a property and issue partnership interest inside of our fund in lieu of paying cash for that owner's equity."

Keith elaborates on the mechanics of the DC Advantage Fund, an evergreen fund that allows for flexibility and liquidity, with no lock-up periods and the ability to redeem investments based on fund liquidity.

8. Real-World Examples and Benefits

Tom and Keith discuss real-world applications, such as an investor contributing a three-unit property appreciated by $200,000 into the fund. This allows the investor to receive units equivalent to the property's value, thereby deferring immediate tax liabilities while gaining exposure to a diversified real estate portfolio.

Keith Nelson [22:16]: "You get 200,000 worth of units and currently, there's a cash flow attached to those units because the fund is cash flow positive."

Keith also touches on the tax planning advantages, where investors can strategically withdraw capital to manage their tax liabilities over multiple years, similar to phased 1031 exchanges.

9. Underwriting and Property Selection

The discussion moves to how Dual City Investments underwrites and selects properties for their fund. Keith describes a meticulous process involving multiple teams—investment acquisition, commercial brokerage, capital markets, and development services—all collaborating to evaluate and approve property contributions based on the fund's criteria.

Keith Nelson [25:03]: "We have investment, we have investor acquisition meeting every week the managers discuss these assets... we have a lot of eyes looking at our acquisition targets."

Currently focusing on core and core-plus assets, the fund emphasizes properties with strong cash flow foundations, ensuring stability and liquidity for investors.

10. Future of 721 Exchanges

Looking ahead, Keith anticipates a growing adoption of 721 exchanges as more funds and advisory firms recognize their benefits. He emphasizes the need for education among investors and their advisors to unlock the full potential of this strategy.

Keith Nelson [26:31]: "I do think in the next couple years, you're going to see a lot more companies... starting to implement this strategy."

11. Conclusion and Takeaways

The episode wraps up with actionable insights for listeners considering a 721 exchange:

• Evaluate Property Compatibility: Ensure your property aligns with the fund’s investment criteria or consider a 1031 exchange to make it compatible.
• Conduct a Cost-Benefit Analysis: Weigh the fees and complexities against the tax deferral benefits.
• Consult Professionals: Engage with legal and tax advisors to navigate the nuanced requirements of 721 exchanges.
• Consider Long-Term Involvement: 721 exchanges are most beneficial for investors looking to diversify and passively invest over time rather than seeking immediate liquidity.

Tom and his guests underscore the strategic advantages of 721 exchanges as a versatile tool for real estate investors aiming to optimize their tax positions while expanding their investment horizons.

For more detailed information and to explore 721 exchange opportunities, listeners are encouraged to visit Dual City Investments and request a comprehensive presentation on their fund offerings.

Notable Quotes:

• Caitlin Deaver [04:18]: "I'm not exactly. And so when I contribute this property to the partnership, the partnership's going to take on the basis that I had in the property at that given time."

• Keith Nelson [15:28]: "The most important part was deferring the capital gains in that transaction."

• Tom [20:55]: "With a 1031 exchange, you sell the property, you're recognizing that capital gain this year... with the 721 exchange, you could pull some capital out incrementally."

Resources:

• Visit Dual City Investments for more information on participating in a 721 exchange.
• Explore additional content at TheRealEstateCPA.com/Podcast and TaxSmartInvestors.com/Insiders.

About the Host and Guests:

• Hall CPA, PLLC: A CPA firm specializing in serving real estate investors and business owners, handling everything from multi-million dollar syndications to small portfolio builds.

• Caitlin Deaver: Tax Manager and Head of Private Equity at Hall CPA, with expertise in partnership taxation and private equity.

• Keith Nelson: Managing Partner of Dual City Investments, experienced in syndicating real estate deals and executing sophisticated tax-deferred strategies like 721 exchanges.

Thank you for tuning into the Tax Smart Real Estate Investors Podcast. Stay informed, invest wisely, and optimize your tax strategies with expert guidance.