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Tax Smart Real Estate Investors Podcast
235. Unlocking the Secrets of the "721 Exchange": An Overlooked Real Estate Exit Strategy
00:28:04
In this two-segment episode, Brandon and Thomas b…
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Tom
You're now listening to the Tax Smart.
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Brandon
REI podcast, your source for all things real estate accounting and tax. Here we reveal our secrets that can save you thousands in taxes, streamline your accounting process, and help grow your business. Stay tuned to hear insightful interviews with industry experts, successful real estate investors, and current clients on what strategies they use to grow their business and how they steer clear of Uncle Sam.
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Tom
Hey, thanks for tuning into this episode of the Tax Smart REI Podcast. Today we have an interesting episode on an exit strategy that we talked about here before here on the podcast, and that is 721 exchanges. And this episode's gonna be basically like a two parter. First we have Caitlin Deaver, who is tax manager and head of our PE division here at our firm. So she's a partnership expert. And then we have Keith Nelson, who is managing partner of Dual City Investments. And Dual City Investments actually Excel steps 721 exchanges. So in other words, we're going to dive more into the details. But long story short, 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. It's kind of similar to a 1031 exchange in that deferral aspect of it. So we're going to dive into all that. So, Kaylin, thank you so much for joining us on the show today. Would you be able to give the audience a little bit of information on your background for those who might be new or haven't heard one of your prior episodes?
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Caitlin Deaver
Absolutely. Thanks for having me back today. Tom, a little different. We're talking about a different topic in partnership taxation today rather than just operating agreements, which is what we've mostly covered in the past. So as Tom mentioned, I am a cpa. I've been with the firm here for about three years now. My background is in private equity. And so that transitioned really well over to the real estate cpa Hall CPA and I lead our private equity large syndication team here at Hall.
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Tom
Awesome. Awesome. So today's topic is obviously the 721 exchange. And I know you know a lot about the 721 exchange dynamics or how the section 721 works. So would you be able to kind of break down what is section 721?
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Caitlin Deaver
Yeah, absolutely. And so I did go ahead and pull up the Internal Revenue code just so I can quote it word for word here for a second and then we'll break it down to make it a little more easy to comprehend. So 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. So what that really means here is when we talk about 1031s, we're talking about exchanging real property for real property. And so a lot of times what we'll see with fund managers or with investors that want to get into a fund is they may own several properties personally or individually, but they can't 1031 that into a partnership interest. So say if I own 10 properties personally. And Tom, you had a large partnership fund and I wanted to join your fund, I can't just 1031 my properties into your partnership fund because it's just not real property for real property. It's real property for a partnership interest. So the section 21 here gives us the flexibility where if my properties matched what you were looking for in your properties in your fund, I can contribute my properties directly to your partnership fund, and your partnership fund would then own those properties at that point.
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Tom
Awesome. Awesome. And say you contribute your properties to my fund, right? What happens to you? What happens on your end? So now the fund owns the properties. What do you get in exchange for? You're not just giving me your properties for free, right?
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Caitlin Deaver
Right. Nope, nope. That's not how it works around here. I'm not handing over any properties for free. So at that point, I am a part of your partnership, and so then I do have a partnership interest. So instead of contributing cash, I've effectively contributed property for my interest in the partnership. So that is allowed. But again, what you're not allowed to do is 1031, so to say, and sell your property and then contribute funds to the partnership. So instead of property to cash to partnership, I'm going property directly to partnership.
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Tom
And when you contribute the property to the partnership, you're not recognizing a capital gain at that juncture in time.
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Caitlin Deaver
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. So say maybe I've held this property for 10 years. Right. And it's appreciated, and I've taken appreciation on the property when I contribute it. That's the value that you're going to take on or the basis that you're going to take on as your partnership fund as well. So you're going to start depreciation, right. From that basis that it left off with when I Had it.
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Tom
Gotcha, gotcha. So as the contributor to the property, when would you recognize, at what juncture in time would you recognize a capital gain?
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Caitlin Deaver
Yeah, so 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 part of the gain, when you eventually sell the property, that first portion of the gain that I had already generated, so to say, from the appreciation when I was holding it, it's first going to be allocated to me and then the gain will go according to your operating agreement or your partnership interest.
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Tom
Got it? Got it. So I get to defer the capital gain now, later on at some point when the property is sold, or if I were to eventually perhaps sell my partnership interest, if I heard you correctly, then at that point I might run into some capital gain issues.
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Caitlin Deaver
Right. So this is a great strategy for someone that, you know, maybe they are currently running several properties on their own and now they want to take more of a passive se. Right. They don't want to be involved in the day to day operations. This allows them to contribute their property up front. They don't have to recognize capital gain because they're not selling the properties, they're just moving them over. And again, then it allows them to take more of a passive seat so they're not worried about the day to day operations. And it also helps with diversification. Right. Maybe I own all of my properties on the coast of North Carolina, but Tom, your partnership fund owns multifamily buildings in all over the Southeast. Right. So it gets me out of one specific market and it's a, it could be a diversification strategy.
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Tom
Nice, nice. I have a few more questions here. So what happens? I know there's some interesting dynamics or there might be some interesting dynamics if, if the property is encumbered by debt. Right. So. So for example, say the property that you contribute to my fund has a mortgage on it like, or you know, has a loan on it like most properties do these days. What happens to that loan or how does that impact the contributor of the property to the fund?
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Caitlin Deaver
Right. So I'll go ahead and give my disclaimer here that I think I give during every podcast episode. This is a highly complex transaction and so do not take exactly what you're hearing in this podcast episode and try to go do a 721 transaction on your own. Highly recommend you talk with your legal advisors and a qualified CPA who has seen this type of transaction before, because there's a lot of nuances. I mean, you heard me earlier. We went from section 721 over to section 7, 704C. Right. So it's not that we're just focusing in on section 721. There's going to be other code sections that flow into and dictate the transaction and affect it from a tax standpoint. So that's my disclaimer there. And then back to your original question, Tom. When you have debt on the property, when you contribute the property, remember we talked about basis. So it's coming over at the basis that I had in the property. But if you had debt, that's going to reduce the basis of the value that I'm receiving when I contribute the property. So the partnership is still going to pick the property up at its basis, but it's going to reduce the value of the contribution amount that I'm receiving. Because think about it. If I were to contribute a property to your partnership, Tom, you're not going to want to give me a $100,000 capital account in your partnership if I gave you a $100,000 property, but it has a $50,000 note on it. Right? Because now your partnership is responsible for this $50,000 note. And so again, a lot of nuances here. And then we also start talking about basis when the loan on the property that you're contributing may exceed the value of the property itself or may exceed the basis in the property. So 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. So it does seem pretty cut and dry that no gain or loss is recognized when you contribute property to a partnership. But that's not always the case. I did not read you section 721B or C. Right. So there are some nuances there that you're just going to want to make sure that you're clear on and work with your legal team and your CPA team before you start moving properties into a partnership.
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Tom
Gotcha. Gotcha. Thank you. Thank you for breaking all this down. So, kind of just to summarize here, because I know we're going to be moving into the other segment of the podcast shortly with Keith, who actually runs one of these types of funds that you can actually contribute your property to kind of summarize here. The section 721 allows an investor or a property owner, rather, to contribute their property to a fund in exchange for a partnership interest. And it's if structured properly for the rules are followed, you follow the proper guidance. It can be a tax deferred transaction in the sense that you contribute your property. You're not recognizing capital gain today, but there are some nuances you have to be aware of. You have debt on the property, there might be some things you have to watch out for. But at the end of the day, it's a 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. That's another exit option. One last thing I just do want to say before we dive into that issue. I think Caitlin brought up a very interesting point before. She said if your fund is accepting the property that she has, right. Not all funds that accept 721 exchanges like we'll take your property are going to accept the property you have. Right? You might have a single family home or you might have a small multi family building. Sometimes what people have to actually go and do is they'll 1031 exchange into the type of property that the fund will accept. Right. So they might accept commercial property or they might accept class A multifamily, for example. So you might have this small multifamily building or this strip mall or something along those lines. You 10:31 exchange it into the property that the fund will accept. You hold that for a period of time, usually somewhere between 18 to 24 months, depending on the situation. If you really want to be safe, the longer you hold it, the better. But then you contribute that new property to the fund and do the 721 exchange.
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Caitlin Deaver
Yeah, Tom, you bring up a really great point. We've seen this in real time with one of our funds. The fund is a single family home fund. They acquire properties all across the United States. They have around 11,000 homes and every single one of those homes is a single family home. So they had an investor come to them and he owned two commercial properties and the fund, you know, that's not our business model. We don't really want those commercial properties in our fund. However, they helped him identify single family homes and so he sold us to commercial properties. 1031 into some single family homes, went through the whole waiting period and then was able to eventually contribute them to the, to the partnership fund in exchange for those partnership interests. So that's a real life example of when a property may not match exactly what the fund is looking for and when, when you may need to take advantage and do a 1031 before you consider a 721. And last thing I just wanted to leave you all with is to consider the cost benefit analysis here. Right. As we talk about a 1031 and 721s, we're talking about qualified intermediaries, you know, additional legal advice, additional tax preparation fees just due to the additional reporting that's required. And so when we think of this, we're probably not thinking of doing this with a $50,000 property or maybe even a $500,000 property. Right. That's up to you and the fund manager that you're working with to determine and to just do a cost benefit analysis so that you're aware of it and you're not shocked by any fees on the back end when considering versus just paying capital gains tax outright.
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Tom
Gotcha. Gotcha. Okay, awesome. Thank you so much for joining us today, Kaylin, and breaking down section 721 and sharing your knowledge with us. We're going to go ahead and dive into the second segment of the episode again with Keith Nelson, and we'll be there in just one moment.
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Caitlin Deaver
Thanks, Tom.
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Tom
Hey, Keith, thanks for taking the time to come on the show today. Would you be able to give our listeners a little information on your background and, like, how you got involved, like Dual City investments?
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Keith Nelson
We'd probably need more than the allotted time to go through my whole background, but it's a Dual City background. We started in 2014, me and my partner, we actually, we met in a law enforcement group in New York City. I moved to Greenville, South Carolina, and that's kind of the name, where the name came from, the Dual City, New York, Greenville. So he would raise capital, I'd find the assets, and we'd started syndicating deals. Since then, I think we've ran through about 25 syndications. And this is our third private equity fund.
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Tom
Nice, nice. And this one, this one's the DC Advantage Fund. And I think the unique aspect of it is you guys accept 7, 721 exchange is like in basically, people contribute the properties. Would you be able to, like, kind of dive into that a little bit?
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Keith Nelson
Yeah, we actually have a couple losses that we, you know, try to make us stand out from the sea of other people. But 721 is definitely the primary differentiator for those who don't know what a 721 exchange is. It's the exchange of partnership interest from one entity to another. And then what that means in our fund is we can take in a property and issue partnership interest inside of our fund in lieu of paying cash for, for that owner's equity. So if there's a five million dollar property and two and a half is debt and two and a half is equity, if we could absorb the debt or we could replace the debt and then we could issue that person, you know, two and a half million of units in front guys.
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Tom
So basically kind of way it works is like to say, for example, I have a property and I need to exit the property, but I want to minimize my tax implications, minimize the capital gains tax, all that good stuff. Then you know, I have a few options available to me. The 1031 exchange. I can go 1031 exchange into another property, but then usually I'm stuck managing that property. Right. And, or I could do like a DST with Delaware Statutory trust where I go put the money in the DST and then somebody else institutional grade. Usually assets are part of that type of deal and I don't have to manage it. But then you have the 721 exchange which actually allows you to contribute your property to the partnership. Right. In exchange for partnership interest effectively. And then you now have another pool of assets that you're invested in. You're diversifying without having to deal with the management aspect of it. And you still get to defer your capital gains tax. Is that kind of like a good summary of it?
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Keith Nelson
I think that was a better summary than I did. Yeah. So yeah, I forgot the most important part which was deferring the capital gains in that transaction. So that's why we had it. We have a sister brokerage company. We see a lot of owners that they want to activate their equity and move on, but they don't like 1031. So this is just another option like you said, other than DST 1031 zones, this is just another tax deferred strategy that we could offer. Ownership.
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Tom
What type of properties typically make the most sense to like absorb into this type of fund? Because it's like single family houses or are you looking at like office buildings? Like what kind of properties typically make sense?
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Keith Nelson
So we are a blindfold fund and we are asset agnostic. We look at each asset, you know, as a standalone opportunity. And if it fits our fund criteria then, and you know, we'll do some research in the market and if that checks off, we'll take that property in. We actually have done some single family homes more so to pad our liquidity access. So you know, if there's a redemption in our fund, this fund Is also an evergreen fund and there's no lockup period. So if investor wants their, their capital out, they put in a redemption request and we turn them capital. And the way we do that is we have lines of credit on a couple larger properties like industrial assets and some of our other commercial stuff. But second strategy is we, we have been taking in some single family homes that are free and clear that you know, if there is a redemption needed, we could either take a full line of credit on that or just liquidate that one home. So we did buy portfolio homes and we're kind of using it with that in the, in the background. Luckily there hasn't been any redemption just yet. But it, you know, we, we like to have that availability to us. And it's a question that investors always ask like if I want my money out, how are you gonna, how are you gonna cash me out? So that's the answer.
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Tom
Got it. Right. So say that I trade in my single family house, I'm in the fund. Right. And now.
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Keith Nelson
Great.
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Tom
I deferred my capital gains tax so I could, you know, not have to worry about that, Continue stay invested in real estate. And then if I wanted to get out of the fund, like if I want to get out the exit of it. Right. From a practical standpoint, you'd have to have a redemption. And at that point that's typically when the capital gains tax would be due. Like when there's either like a redemption or there's like a return of capital. That's usually when that capital gains event starts to get triggered.
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Keith Nelson
Correct? Yes. Yeah. This is tax deferred, not it's forgiven. So it works the same way as a, you know, as a 1031. If you exit 1031 go to cash, your basis is going to be capping. You're going to pay the gains on what you cashed out. Same thing with 721. It also works the same way with the stepped up basis currently. So you know, if you 1031 several times you left it to your heirs, you pass away, your heirs inherit that asset of stepped up basis. Same thing happens with the units in our fund. So if they come in and you know it's a, they come in at a dollar per unit certainly and you know, they leave it in errors at from $6 per unit. They get it at that stepped up basis.
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Tom
Nice, nice. So it's like another nice little tax perk of being able to use a strategy like the 721 exchange.
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Keith Nelson
Yeah, yeah. And I'm a little biased but, you know, the huge benefit, the way our fund is set up is you could tax plan with this, right? More so than at 1031. 1031 is usually all or nothing. You sell that asset, that's it, you got to pay the taxes next that year. But, you know, with our strategy, we've advised some, some owners, you know, come in and you can pull your money out incrementally, you know, so you could tax plan for the future. If you take a loss somewhere else, you know, you might want to pull some capital out that year and strategize tax planning. So it could be a really useful tool. And we've seen it work well in a couple scenarios. For some owners, our biggest hurdle is just educating people because they never heard of it, their accountants never heard of it, their wealth advisors never heard of it. So we're kind of fighting an uphill battle of like, you know, this is a real thing and here, here's look and, you know, could talk to our lawyer who put this together. But at the same time, we have to tread that line of almost sounding like we're offering, you know, 1031 deferred strategies along with liquidity, along with cash flow, along with, you know, a stepped up basis. So sometimes it sounds too good to be true to some investors and owners.
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Tom
What I've always found really interesting about the Strategy is the 721 is right in the partnership rules. It's like, not even that. I mean, there's some nuances to it, of course, when you're using a particular strategy like this. But I mean, for the most part, it's like pretty black and white within the tax code. So it's just. I'm surprised with the popularity of the 1031 exchange that something like this hasn't, like, this hasn't been a more popular option for people to exit their properties. Because like you said, I mean, I think one of the bigger benefits too of this is that the fact is with a 1031 exchange, like you said, you sell the property, you're recognizing that capital gain this year. Unless you do like another 1031 right here, you could pull it out incrementally and recognize the capital gains over a much longer period of time, because you're not necessarily liquidating your entire position at one point in time, if that makes sense, or in one tax year.
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Keith Nelson
Yeah, and that's more mechanics of our fund than it is the rules of the 721, as you know. So we set up our fund to be able to do that. I'M sure there's other funds out there that accept 721s and it is an all or nothing scenario. But the mechanics of ours with the evergreen component, the no lockup period and all that, I think the combination of that and the 721 make it an attractive option for investors.
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Brandon
So let's take a step back for a second and let's talk through an actual example. Let's say that I own a 3 unit property and it's 3x in value. Maybe I'm sitting on a $200,000 gain. Do I just contribute that property to the fund or am I selling it, getting a replacement property and then contributing it to the fund? Talk to me about that.
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Keith Nelson
Typically, your first option is what we look for. So you want to exit your property, you want to activate some equity, or you want to get off management, whatever you come to us, we say, okay, we either like this for a long term hold or we know we can roll out of it and we can 1031 to something, you know, along with some other capital, you know, buy something larger or more long term than the three units. So we take that asset in. Did you say your total gains was $200,000?
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Brandon
Yeah.
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Keith Nelson
Okay, so you, you get 200,000 worth of units and currently, you know, there's a cash flow attached to those units because the fund is cash flow positive. And we take that asset in from there. We could decide, okay, we want to hold this, there's maybe a value add component to it, whatever, we could hold it in fund or if we sell it, we have the 1031. If we sell it for cash, you would get hit with the tax liability. However, in our docs, you know, we do cover that. If we mess up on something, then we'd have to come back and cover the taxes for you. But essentially, yeah, you're in that for your gain.
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Brandon
So I think that the reason that people don't know that this exists is because, I mean, I know that we're calling it an exchange, but it's really not an exchange. It's just partnership tax law. You can just contribute property to any partnership and not recognize gain. I mean, for the most part under section 721, so when I contribute the property, so I get $200,000 of units, what happens my basis in the property that I originally had, like if I've got my adjusted basis. And also what happens to my debt basis, like if you are you alleviating me of debt and how does that work?
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Keith Nelson
So if there's debt we can, we can absorb that. As long as we 1031 and we follow those rules, then there's no liability. If we break that, then you're going to have, there's liabilities on the debt, equity that's not replaced.
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Brandon
Got it. So I mean the ideal candidate for your fund is twofold. It's somebody that doesn't want to manage their properties anymore. They, they want diversification. So it's somebody that's going to stick around for a while. Right. Like they're not. This isn't like some thing where I'm going to contribute and then immediately pocket 200k or something. I'm contributing and I'm a fund member for a long time.
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Keith Nelson
Yeah, yeah, yeah.
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Brandon
And then the other aspect of this, or kind of an ideal candidate for this is at least on the fund side is you guys have to make sure you actually want that property and want to 1031 that property.
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Keith Nelson
Yeah. So we either have to want it for a long term hold or know that we can exit it, you know, when it's time to exit. But yeah, I mean, look, we have actually more cash investors in the fund than we do 721 investors. So when you exit. But that, that 200 grand, what I was saying, yeah, you don't want to contribute a property and then withdraw your capital out right away. There's no point. Right. You might as well just sell it traditionally. But what you could do is tax plan that 200k. So year one take out 50, year two, take out another 50, so on and so forth.
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Brandon
How do you underwrite the deals? How do you know if this contribution of property is something the fund actually wants?
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Keith Nelson
I mean we have investment, we have investor acquisition meeting every week the managers discuss these assets. We also have a sister commercial brokerage company and a capital markets team and a development services team. So we have a lot of eyes looking at our acquisition targets. So, you know, the brokerage might give us an opinion of value on it. We may run it through a lender, see what their valuation is on it and then we'll have a meeting and take a vote whether, whether it fits our criteria or there's a plan B for it.
- [25:37]
Brandon
Are there certain types of assets you're looking for?
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Keith Nelson
Yeah, right now we're looking at core, core plus assets. We want to get a nice strong cash flow foundation of the fund before we start taking on some more riskier assets. Last year was our first year in operation and quarter three and quarter four, the interest rates started going all wonky and we kind of put our capital raising on hold. Our acquisition targets dried up. Our deal flow kind of dried up. So we do believe quarter two this year is going to bring more opportunity. And we're just gearing up for that. That run now, huh?
- [26:14]
Brandon
Very interesting.
- [26:15]
Tom
Yeah.
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Keith Nelson
But, yeah, sorry. To answer your question, Brandon. Yeah, we will look at anything, really, if it makes sense for the fund, if there's a plan for it.
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Tom
All right, cool. So anything else, Anything else that would be major to hit on, Maybe like the 721 exchange aspect of it that we haven't already touched on?
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Keith Nelson
Yeah, I mean, just, I, I do think in, in the next couple years, you're going to see a lot more companies, a lot more, you know, funds, syndications, advisors, starting to, to implement this, this strategy. And, you know, hopefully more people are educated on it. But I, I do think it checks a lot of boxes for a lot of different folks.
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Tom
All right, if anybody wanted to learn more about this or like, you know, get involved, how would they be able to do that?
- [26:57]
Keith Nelson
The website dualcityinvestments.com you can request a deck. We could, you know, that goes pretty in depth of our fund and how it operates, our targets and, you know, the returns and, and all that stuff.
- [27:10]
Tom
All right. All right, so if we'll, we'll go ahead and put that in the show notes. If anybody wants to check that, you can go ahead and do that. Keith, want to thank you so much for taking time to come on the show today and sharing, sharing the strategy with everybody.
- [27:21]
Keith Nelson
Yeah, thanks. Thanks, Tom. Thanks, Brandon.
- [27:23]
Brandon
Thanks for listening to today's show. If you enjoyed the show, please find us on itunes and leave us a review. You can also email us@contactherealestatecpa.com with any feedback or topic suggestions. We are always taking on new clients and with the new tax laws in play, you really don't want to navigate this alone. Let us help you save money on taxes with your accounting and CFO needs to become a client. Navigate to our client page@therealestatecpa.com and fill out a web form with as much detail about your situation as possible. Thanks so much for listening. Have a great rest of your week.