Tax Strategies: What You Need to Know About the 721 Exchange vs. the 1031 Exchange

Tax season is here, and if you’re a real estate investor, it’s more than just a time to file your returns—it’s an opportunity to take a hard look at how you can control and minimize your tax burden. If you’re considering selling properties within your portfolio, chances are you’re facing a significant tax liability. The good news is, there are ways to defer those capital gains taxes and depreciation recapture taxes, potentially saving you hundreds of thousands—if not millions—of dollars in the long run. Two of the most common strategies for doing so are the 721 Exchange and the 1031 Exchange. But which one is the right fit for you? Let’s dive into what each of these strategies entails, how they differ, and how they could impact your investment approach.

What is the 721 Exchange?

The 721 Exchange, named after Section 721 of the U.S. Internal Revenue Code, is a relatively lesser-known but powerful tool for real estate investors who are looking to defer capital gains taxes and depreciation recapture taxes. While many people are familiar with the 1031 Exchange, the 721 Exchange offers some unique advantages that are a game-changer for certain investors.

Here’s How It Works

Instead of going through the hassle of selling your property and purchasing another one (like in a 1031 Exchange), the 721 Exchange allows you to exchange your property for shares in an operating partnership or a real estate fund. In essence, you exchange the ownership of your real estate for ownership in a fully managed, diversified real estate portfolio, such as Flock Homes' real estate fund, which is comprised of hundreds of SFR properties.

This strategy is appealing because it continues to offer you exposure to real estate appreciation and provides you with ongoing income from the fund, all without the need for active management. You no longer have to be a landlord juggling tenants, repairs, or the day-to-day responsibilities of property management.

But there’s more. Since you own shares in the fund, you also have the flexibility to liquidate your equity in part or in full. That means you can control how and when you realize any gains. And while you’re still liable for capital gains taxes when you redeem your shares for cash, the key benefit here is flexibility. For instance, instead of selling a $400,000 property in one go, which would likely trigger a large capital gains tax bill, you could, following any applicable minimum hold period, choose to sell or redeem $50,000 worth of shares per year over a few years, potentially reducing your overall tax burden by spreading it out over time.

Additionally, the 721 Exchange offers a huge tax-saving benefit upon your death. When you pass away, your heirs will benefit from a "step-up in basis." This means the cost basis of the shares resets to the current value, and your heirs would only pay taxes on any appreciation from that point forward. This can be an enormous benefit if you’ve built up substantial gains in your real estate holdings.

The 721 Exchange was traditionally reserved for large Wall Street institutions and wealthy investors. However, Flock Homes is changing the game by making it accessible to individual real estate investors like you. Now, you don’t need to be a fund manager or large corporation to take advantage of this tax-deferring strategy.

How Does the 1031 Exchange Compare?

On the other hand, the 1031 Exchange is a well-known and widely used strategy that also allows you to defer capital gains and depreciation recapture taxes. However, its process and requirements differ, making it better suited for investors who are still in growth mode and actively managing their properties.

The 1031 Exchange works by allowing you to sell one investment property and reinvest the proceeds into a “like-kind” property—another investment property that is of equal or greater value. The tax liability is deferred as long as the proceeds are reinvested in a similar property within the strict timelines dictated by the IRS (usually 45 days to identify new properties and 180 days to close on them).

While the 1031 Exchange can offer significant tax benefits, there are some challenges involved:

• Complexity and Timing: The process is much more complicated than the 721 Exchange. It involves multiple steps, including at least two closings, and the use of an intermediary to hold the proceeds from the sale. The clock is ticking, and if you fail to meet the stringent deadlines, you risk losing the tax-deferred status of the transaction.
• Active Involvement: With a 1031 Exchange, you continue to own and manage real estate. This means you are still responsible for property management, maintenance, and dealing with tenants. If you’re looking for a way to transition out of the active management side of real estate investing, the 1031 Exchange might not be ideal for you.
• Limited Flexibility: Unlike the 721 Exchange, you cannot split the sale of a property into smaller pieces. If you want to sell part of your investment, you would have to sell the entire property. Additionally, the 1031 Exchange doesn’t offer the same flexibility when it comes to controlling your tax burden. You must reinvest all proceeds in new properties—there’s no option to keep some cash on hand while deferring taxes.

So, Which is Right for You?

Deciding between the 721 Exchange and the 1031 Exchange depends on your investment strategy, goals, and the amount of time and effort you want to spend managing your properties.

• If you want to remain an active investor and continue owning physical properties, the 1031 Exchange might be your best option. It allows you to continue growing your portfolio without paying immediate taxes, and it provides flexibility to change your investment focus. However, be prepared for the complexities of the process and the ongoing responsibilities of property management.
• If you’re looking for a permanent exit strategy and want flexibility in managing your liquidity and taxes, the 721 Exchange is more appealing. With this option, you can step away from the day-to-day grind of property management, while still benefiting from exposure to real estate through a professionally managed fund. Plus, the ability to spread out your tax liability over time—and the step-up in basis for your heirs—are significant benefits that can offer long-term savings.

Final Thoughts

Tax season doesn’t have to be a stressful time for real estate investors. And if you’re dealing with costly capital gains taxes, the right tax-deferring strategy can make all the difference. If you’ve spent decades building your wealth through real estate, you owe it to yourself to explore your options.

Ultimately, the choice between the 721 Exchange and the 1031 Exchange comes down to what makes sense for your investment strategy and long-term goals. But one thing is clear—now is the time to take control of your tax burden and make a move that could benefit you and your family for years to come.

At Flock Homes, we’re making the 721 Exchange easy and more accessible than ever for individual investors, helping you save significantly on capital gains taxes while simplifying the process. If you're ready to learn more, or get a free valuation of your property, we’re here to help you make the most of your real estate investments.