By Carl E. Sera, CMT.
A 72-year-old client has done three 1031 exchanges over 30 years. He started with a duplex and now owns a $3.1 million self-storage facility with a basis under $400,000. He has played the game well. He is also finished playing it.
He does not want another building, another 45-day deadline, or another decade of tenants. He does not want to hand the IRS $700,000 either. And his children have told him, kindly, that they want the money and not the facility.
For years the answer to that client was “pick one.” Today there is a better answer.
In a 721 exchange, a property owner contributes real estate to a REIT’s operating partnership and receives partnership units in return. A properly structured contribution generally defers the gain, so the tax bill he has been deferring for 30 years keeps waiting. What changes is what he owns: instead of one storage facility, he holds a slice of a large, professionally managed portfolio, with income, diversification and a way to take money out over time. For a client at the end of the 1031 road, it is the off-ramp.
How clients get there
Few REITs will take a single property directly. The common route runs through a Delaware Statutory Trust. The client completes an ordinary 1031 exchange into a DST whose sponsor plans to contribute the properties to its REIT’s operating partnership, usually two to three years later. Step one is a normal exchange the CPA already knows. Step two is the 721 contribution. Programs differ on whether the second step is automatic or elective, which is worth a look at the documents, but the sequence itself is well-trodden.
1. He stops being concentrated
Most of this client’s net worth has sat in one building in one submarket for a decade. After the contribution he owns a share of dozens of properties across sectors and states. His dependence on one roof, one tenant and one local economy drops sharply. The receiving portfolio has its own sectors and markets to review, the way you would review any business he was buying into, but for many clients this is the biggest improvement in their financial picture in years.
2. He gets a path to liquidity
This is what clients want most and what a building can never provide. After a holding period, usually one to two years, he can ask the REIT to redeem units for cash. Programs set quarterly limits and can pause redemptions when requests outrun available cash, so this works like a drawdown plan rather than a sale: request $150,000 a year to supplement retirement, leave the rest invested. He plans around the program’s limits rather than counting on a date. Still, for 30 years his wealth was locked in concrete. Now there is a door.
3. The deferral keeps working, and then it ends the right way
The old gain travels with him into the partnership. Redemptions are taxable as he takes them, which lets him manage his bracket year by year instead of swallowing one large bill.
And if he holds the units until death, his heirs generally receive a stepped-up basis in them, which can eliminate most of three decades of deferred gain. His children inherit an investment they can redeem over time, not a storage facility they would have to learn to run. For this client, that is usually the real reason he says yes.
4. His life gets simpler
He trades a property manager, a repair ledger and a rent roll for a Schedule K-1 from the partnership, possibly with a state return where the portfolio owns property. The tax reporting is different rather than lighter. The management responsibilities are gone.
5. It is a one-way door, which is the point
Partnership units cannot be exchanged under Section 1031 again. For a client who might want to buy another property someday, that is a reason to wait. For the client who is finished, it is exactly what he came for: no more deadlines, no more identification letters, no more cycle.
What the CPA adds
The CPA makes this decision concrete. Put three outcomes side by side: keep the building, do another 1031, or move into the partnership. Show the tax, the cash flow and the reporting for each. Confirm the program’s tax opinion, keep his basis history in the file, and look at how his share of debt changes in the contribution so there are no surprises.
Then let him choose the life he wants. Most clients who have spent 30 years building a real estate portfolio have never been offered a way to retire from it without paying the tax. Being the one who shows them is good for the client and good for the practice.
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Carl E. Sera, CMT, is president and managing principal of Sera Capital Management, LLC, a fee-only fiduciary investment adviser specializing in 1031 exchanges, Delaware Statutory Trusts and 721 UPREIT exchanges.
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