Owning multiple properties outside a personal home and vacation homes can bring in passive income. However, 1031 and 721 exchanges are excellent real estate investment exchange mechanisms to defer capital gains taxes.
However, there are slight nuances in how they will affect your portfolio. So, what are the differences between 721 and 1031 exchanges? Here’s a guide to help you understand how each exchange operates and how you can potentially benefit as a property owner.
What Is a 721 Exchange?
A 721 exchange is a resource used by real estate investors. If you find a portfolio or trust that expresses interest in purchasing your property in favor of swapping, you can trade for shares in an investment trust. Something to know about 721 exchanges is that they allow you to earn a steady income and upside potential, transitioning from an active investor to a passive one.
Like a 1031 exchange, 721 exchanges don’t trigger taxable events; you won’t have to pay taxes on exchanges until share redemption. In addition, you can do it all at once or spread it out over time, and you get shares in a diverse portfolio that protects your investment from unpredictable market changes.
What Is a 1031 Exchange?
1031 exchanges allow you to trade one investment property for another and defer capital gains taxes. According to the IRC Section 1031, real estate investors must find “like-kind” replacement assets to qualify.
A 1031 exchange helps you grow your real estate investment without paying expensive taxes. However, it isn’t tax-free—you must pay taxes when selling your replacement property unless you pass away, in which case your heirs won’t have to pay capital gains taxes.
What Are Their Differences?
Now that you know more about 721 and 1031 exchanges, let’s review their differences. What responsibilities, ownership capabilities, and diversification opportunities will you have with each?
Responsibility
Ownership of a property comes with a plethora of responsibilities. In situations where you can’t find tenants for your property, you’ll deal with vacancy costs. Similarly, you must deal with paying for repairs directly out of your wallet.
When you go with a 721 exchange, you won’t have maintenance and management responsibilities. However, 1031 exchanges keep you as a direct, active owner where you still have responsibilities on your shoulders.
Diversification
721 exchanges allow for diversification by giving you instant access to extensive portfolios of different property locations and types. 1031 exchanges help diversify your portfolio, especially if you already own other real estate types.
Ownership
In a 1031 exchange, you have complete control of decisions regarding your property. In a 721 exchange, you make a trade that relinquishes ownership of the real estate. You instead own shares in a partnership or trust that has 100 percent control over the property.
Not every property can qualify for a 721 exchange, but they can all be used in a 1031 exchange. Both exchanges can help with tax deferrals but can lead you down two different paths. See what you have in your possession and speak to a financial fiduciary advisor to get you started.
