Differences Between IRS Section 721 and Section 1031 Exchanges

A Section 721 exchange and a Section 1031 exchange are similar in many ways, as both provide tax-deferral benefits for real estate investors. However, they are different in terms of their application, types of properties involved, and specific rules. Let’s explore the key differences between these two types of exchanges.

1. Legal Basis:

• Section 1031 Exchange: This is governed by Internal Revenue Code (IRC) Section 1031, and it's the more commonly known tax-deferral exchange. It allows an investor to defer paying capital gains taxes when exchanging one investment or business property for another "like-kind" property.

• Section 721 Exchange: This is governed by IRC Section 721, and while it shares some similarities with Section 1031, it is more often associated with the exchange of real estate for partnership interests, particularly within real estate investment trusts (REITs) or real estate syndications.

2. Property Types:

• Section 1031 Exchange: The properties exchanged must be of "like-kind" and typically involve real estate held for investment or business purposes. For instance, an investor can exchange one piece of real estate for another (e.g., a rental property for a commercial building). The key requirement is that both properties must be real estate.

• Section 721 Exchange: A Section 721 exchange allows the exchange of real estate for partnership interests in a real estate partnership, such as a real estate investment trust (REIT) or a real estate syndication. This means the investor is exchanging their real estate property for an ownership interest in a partnership, rather than swapping it directly for another piece of real estate.

3. Exchanging Property for Partnership Interests:

• Section 1031 Exchange: In a Section 1031 exchange, the investor exchanges one piece of property for another piece of real property. There is no direct involvement of partnership interests or shares.

• Section 721 Exchange: A Section 721 exchange is more specific in that it allows investors to exchange real estate for ownership interests in a partnership (usually a REIT or a private syndication). This means the investor essentially "exits" from direct ownership of real estate and becomes a shareholder or partner in the investment entity.

4. Tax Deferral Mechanism:

• Section 1031 Exchange: This type of exchange is often used to defer taxes on capital gains and depreciation recapture. The investor defers paying taxes on the gain from the sale of their property, as long as the proceeds are reinvested in another like-kind property.

• Section 721 Exchange: Similar to a 1031 exchange, a Section 721 exchange allows for the deferral of taxes. However, the deferred tax liability is tied to the partnership interests (e.g., REIT shares) instead of a direct property exchange. Essentially, the investor becomes part of a pooled real estate investment rather than continuing direct ownership of real estate assets.

5. Use of Qualified Intermediaries:

• Section 1031 Exchange: A Section 1031 exchange typically requires the use of a qualified intermediary (QI). The QI holds the proceeds from the sale of the old property and facilitates the purchase of the new property, ensuring that the transaction qualifies for tax deferral.

• Section 721 Exchange: A Section 721 exchange does not necessarily require the use of a qualified intermediary, as the exchange is not between two properties but rather between a property and a partnership interest. However, there are still regulations to follow, such as ensuring the real estate is being exchanged for qualifying partnership interests.

6. Investment Control and Structure:

• Section 1031 Exchange: In a Section 1031 exchange, the investor retains direct control of the real estate investment. They are still the owner of the new property, which they manage, rent out, or sell later on.

• Section 721 Exchange: When using a Section 721 exchange, the investor relinquishes control of the direct property ownership and instead receives shares or partnership interests in a syndicate or REIT. This means they no longer have direct management over the property, as it is managed by the partnership or trust. This is a more passive investment option compared to a 1031 exchange.

7. Eligibility for Different Investor Types:

• Section 1031 Exchange: Section 1031 exchanges are primarily used by individual investors, partnerships, and corporations holding real estate for investment or business purposes.

• Section 721 Exchange: Section 721 exchanges are often used by individuals who want to move from direct real estate ownership into more passive investment vehicles like REITs or real estate syndications. This may appeal to investors looking for diversification or those seeking a more passive investment structure.

8. Long-Term Investment Strategy:

• Section 1031 Exchange: The 1031 exchange is typically used by investors who want to continue to own and manage real estate properties over the long term. They aim to defer taxes while continuing to grow their real estate portfolio.

• Section 721 Exchange: The 721 exchange is typically a strategy for investors who want to "exit" direct ownership of real estate and move into a more passive, diversified form of real estate investment. This may appeal to those seeking to reduce the complexity and responsibility of property management or those looking to invest in larger, institutional-grade properties.

9. Exit Strategy:

• Section 1031 Exchange: Since the 1031 exchange involves direct property exchanges, when the new property is eventually sold, the investor will have to pay taxes on the deferred capital gains (and depreciation recapture) unless another 1031 exchange is executed.

• Section 721 Exchange: After a Section 721 exchange, the investor has the option to exit by selling their partnership interest (e.g., REIT shares or syndication shares), but this will usually trigger taxes at that point, depending on the investor’s specific tax situation. However, this is still a way to diversify without immediately triggering taxes.

Summary of Differences:

Feature	Section 1031 Exchange	Section 721 Exchange
Legal Basis	IRC Section 1031	IRC Section 721
Property Type	Like-kind real estate	Real estate for partnership interests
Tax Deferral	Capital gains on real estate	Tax deferral on real estate for partnership interests
Investment Control	Direct control over real estate	Passive ownership in REITs or syndications
Use of Qualified Intermediary	Required	Not necessarily required
Exit Strategy	Continue real estate ownership	Exit into more passive investments

In conclusion, both Section 1031 and Section 721 exchanges offer valuable opportunities for real estate investors to defer taxes and grow their portfolios. However, these exchanges involve complex rules and regulations that require careful planning and attention to detail. Whether you are looking to reinvest in like-kind properties or transition into passive investment vehicles like REITs, it’s crucial to seek guidance from experienced real estate, legal, and tax professionals to ensure that you fully understand the implications of each strategy. Proceeding with caution is essential, as even small missteps in timing, property eligibility, or compliance could result in unintended tax liabilities. By working with the right professionals, you can make informed decisions that align with your long-term investment goals while minimizing risks. 721ce.com is an excellent resource to reach out to for such assistance.