How Bay Area Property Owners Can Defer Taxes and Earn Passive Income via Section 721 Exchange

If you’re like many Bay Area real estate investors, you’ve probably owned your rental property for years—maybe even decades. And thanks to the skyrocketing appreciation in places like Cupertino, Santa Clara, or San Jose, you’re sitting on a lot of equity. But when it comes time to sell? The capital gains tax bill can feel like a gut punch. That’s where a lesser-known tool called a Section 721 exchange comes in. It’s a smart, tax-efficient strategy that lets you trade your rental property for shares in a Real Estate Investment Trust—or REIT—and defer your taxes while gaining diversified, passive income.

What is a Section 721 Exchange?

A Section 721 exchange is part of the Internal Revenue Code that allows you to contribute real property to an operating partnership (usually part of a REIT structure) in exchange for ownership units in that partnership. Over time, these units are typically converted into REIT shares, giving you access to income-producing, diversified real estate—without the burdens of being a landlord.
Unlike a 1031 exchange, where you have to swap one piece of real estate for another, the 721 exchange is about exiting active real estate management entirely. It’s an ideal option for folks ready to retire from being landlords but not ready to hand over a big chunk of their sale proceeds to the IRS.

How the Process Works

Here’s a simplified step-by-step breakdown of how the 721 exchange typically unfolds:

1. Sell Your Rental Property into an UPREIT (Umbrella Partnership REIT):

   A qualified REIT sponsor will agree to acquire your property. Instead of paying you cash, they’ll give you Operating Partnership Units (OP Units).

2. Receive OP Units, Not REIT Shares (Yet):

   These units represent an interest in the REIT’s operating partnership. They’re not liquid, but they can be converted into REIT shares over time.

3. Defer Capital Gains Tax:

   Because it’s considered a contribution of property—not a sale—you don’t pay capital gains tax at the time of the transaction.

4. Start Receiving Income:

   You start receiving income distributions from the REIT’s real estate holdings. These distributions are often paid quarterly and may include rents from offices, apartments, industrial spaces, and more.

5. Convert OP Units into REIT Shares:

   Over time (or whenever you decide), you can convert your OP Units into liquid, publicly traded REIT shares—and either sell those for cash or keep holding them for income.

Your Neighbor Sold their House too Cheap!

The Big Benefits of a Section 721 Exchange

One of the biggest benefits of a Section 721 exchange is the ability to defer capital gains taxes while transitioning from actively managed real estate into a diversified, income-producing portfolio through a REIT. For Bay Area property owners sitting on highly appreciated assets, this can mean deferring hundreds of thousands of dollars in taxes while eliminating the headaches of landlord responsibilities.

Instead of managing tenants, maintenance, and local regulations, investors receive regular dividend income from professionally managed real estate spread across the country. A 721 exchange also allows for estate planning advantages, as the deferred taxes may be eliminated entirely through a step-up in basis upon inheritance. It’s a powerful tool for investors who want passive income, tax deferral, and long-term financial flexibility.

Let’s break down why this approach is gaining traction, especially for longtime property owners in the Bay Area:

1. Tax Deferral

The biggest win? You defer capital gains tax. Depending on your basis and appreciation, this could save you hundreds of thousands of dollars in immediate tax liability. No 45-day identification window, no like-kind requirement—just a straight-up contribution.

2. Eliminate Landlord Duties

Being a landlord in the Bay Area isn’t easy. Between rent control laws, maintenance headaches, tenant protections, and skyrocketing insurance costs, managing a rental here can feel more like a second job. A REIT handles all of that for you.

3. Diversification

Instead of having all your eggs in one Bay Area duplex or single-family home, your new REIT shares are spread across hundreds—sometimes thousands—of properties across the country. That’s diversification you simply can’t replicate as a solo investor.

4. Passive Income

REITs are legally required to pay out at least 90% of their taxable income to shareholders as dividends. That means regular, reliable income. And for retirees, this can act like a replacement for rent checks—without the tenant calls.

5. Estate Planning Benefits

When you pass away, your heirs receive a step-up in basis. If they inherit REIT shares, they can sell them without paying the deferred capital gains tax. This is a huge advantage for generational wealth planning.

The Potential Drawbacks

While a Section 721 exchange offers compelling tax and income benefits, it’s not without its drawbacks. First and foremost, once you contribute your property to a REIT, the decision is irreversible—you can’t reclaim the property or later choose a 1031 exchange instead. Additionally, the Operating Partnership Units (OP Units) you receive aren’t immediately liquid and may be subject to holding periods or conversion restrictions.

There’s also the risk tied to REIT performance—not all REITs are created equal, and market fluctuations can impact both dividends and share values. When you eventually convert OP Units into REIT shares and sell them, you’ll trigger the deferred capital gains tax, so the deferral is temporary, not permanent. Finally, by moving into a REIT, you lose direct control over the management and decisions involving the real estate assets, which may not suit every investor’s style or comfort level.

Bottom line, here are some of the important caveats to consider before going all-in on a 721 exchange.

1. No Reversing Back

Once your property is contributed to the REIT, there’s no do-over. You can’t take it back or decide later that you want to 1031 it into another apartment complex. It’s a one-way street.

2. Liquidity Limitations (Initially)

OP Units aren’t publicly tradable. You can’t cash them out until they’re converted into REIT shares, which may have lock-up periods depending on the sponsor. If you need cash fast, this may not be ideal.

3. REIT Performance Risk

Not all REITs perform equally. Some focus on sectors that are more volatile—like office space or retail. You’ll want to choose a REIT with a solid track record and diversified portfolio.

4. Tax on Conversion

When you eventually convert OP Units into REIT shares and sell those shares, you’ll pay capital gains tax at that time. The deferral isn’t forever—it just buys you time.

Point. Click. Offer. Sell.

What Does It Cost?

In most cases, the REIT or sponsor covers the transactional costs, which makes the 721 exchange relatively inexpensive compared to selling a property outright and reinvesting post-tax proceeds. However, it’s not completely free:

• Legal and Advisory Fees: You’ll want a real estate attorney and a tax advisor experienced with 721s.
• REIT Internal Fees: REITs charge management and operational fees—usually built into the structure.
• Liquidity Discounts: Some sponsors may structure the acquisition at a slight discount to your property’s market value, often 3-10%, to account for the REIT assuming management responsibilities and risk.

What Kind of Return Can You Expect?

Returns vary depending on the REIT and market conditions, but here’s a general benchmark for publicly traded REITs:

• Dividend Yields: Typically between 3% and 7% annually.
• Total Return (including share appreciation): Historically, REITs have delivered average total returns in the 8%–12% range, though past performance is no guarantee of future results.

Compared to the Bay Area rental market, where cash flow can be razor-thin and appreciation is unpredictable, REITs can offer more stable income, especially if you’re prioritizing yield over appreciation.

Tax Implications to Keep in Mind

Let’s zoom in on some of the tax nuances:

• Depreciation Recapture is Deferred: When you exchange into a REIT via 721, depreciation recapture tax is deferred too.
• No New Depreciation: You stop depreciating your property once you swap it into the REIT.
• Eventual Capital Gains Tax: Once you sell REIT shares, you trigger capital gains tax—but possibly at a time when your income (and tax bracket) is lower.

And as mentioned earlier, your heirs may benefit from a full step-up in basis, avoiding that tax altogether.

Can You Get Your Money Out?

Getting your money out of a REIT after a Section 721 exchange typically happens in phases, offering both flexibility and control over taxes. Once your rental property is contributed to the REIT, you receive Operating Partnership Units (OP Units), which aren’t immediately liquid. However, over time—and depending on the REIT’s structure—you can convert these OP Units into publicly tradable REIT shares. From there, you can gradually sell those shares to access your funds, spreading the tax impact across multiple years. Alternatively, some investors choose to hold the shares indefinitely for steady dividend income, or even borrow against them using a margin loan or securities-backed line of credit to access cash without triggering a taxable event. This layered approach provides options whether you want income now, later, or a combination of both.

In a nutshell, these are your options:

1. Convert OP Units Gradually

Most REITs allow you to convert your units over time. This phased approach lets you manage your tax exposure year by year.

2. Sell REIT Shares for Cash

Once you’ve converted to REIT shares and cleared any lock-up periods, you can sell them on the public market, assuming it’s a public REIT.

3. Borrow Against Shares

Some investors use margin loans or securities-backed lines of credit to access liquidity without triggering a taxable event.

Who is the Ideal Candidate for a Section 721 Exchange?

This strategy is tailor-made for:

• Bay Area landlords tired of tenant issues
• Owners of highly appreciated rental properties
• Empty nesters or retirees looking to simplify
• Estate planners aiming to preserve generational wealth
• People nearing retirement who want regular income without managing property

If you’re looking to gradually wind down active management while still enjoying real estate returns—and keep Uncle Sam out of your pockets a bit longer—this can be a game-changing option.

Real World Example

Let’s say you own a duplex in Sunnyvale you bought in the early 2000s for $600,000. Today, it’s worth $2 million. After depreciation, your adjusted basis is around $300,000. If you sell, you’re looking at:

• Capital Gains Tax: ~$255,000 (20% Fed + 3.8% NIIT + CA tax)
• Depreciation Recapture: ~$100,000

That’s over $350,000 in taxes. But if you contribute the property into a REIT via a 721 exchange, you defer all that, receive OP Units instead, and begin receiving 5-6% annual income on your new investment—roughly $100,000+ per year. And if you convert slowly into liquid shares, you can control your taxes along the way.

Final Thoughts: Is This the Right Move?

For some of my clients, a 721 exchange into a REIT is the missing piece in their wealth strategy. It frees them from landlord duties, diversifies their holdings, generates predictable income, and helps them avoid massive capital gains in one fell swoop. But it’s not for everyone. If you’re still interested in actively investing, or if you need liquidity right away, it might not be the best fit.

That’s why it’s so important to talk to your tax advisor, financial planner, and a real estate professional who knows the nuances of these transactions.
If you’re sitting on a property in San Jose, Santa Clara, or anywhere else in Silicon Valley and you’re curious if a 721 exchange could make sense for you—let’s talk. I can help you explore whether this strategy fits your goals, connect you with qualified REIT sponsors, and walk you through what to expect step by step.

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