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Real Estate's Best-Kept Secret: This Little-Known Loophole Is Going to Change How You Invest

This game-changing loophole gives the average investor access to mega deals.

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In real estate, one of the most pro tactics is the 1031 Exchange -- also known as the secret behind how Donald Trump and other real-estate developers pay almost nothing in taxes.

Yukinori Hasumi | Getty Images

Related: Crowdfunding Is Lowering Barriers to Commercial Real Estate Investment. Here's How to Get the Most From It.

However, there's another, little-known tax loophole that Real Estate Weekly, a New York real estate trade publication, calls real estate's "best kept secret."

To me, I call it the 1031 on steroids. This beauty is known, simply, as the 721 Exchange.

Like the 1031, 721 Exchange allows you to defer capital gains tax. Unlike the 1031, you can exchange your capital gains into a portfolio versus just one property. The 721 also allows you to get into REITs.

721: What it is

The 721 Exchange is a little-known law that -- much like the 1031 Exchange -- allows property owners to defer capital gains taxes. In fact, you essentially have all the benefits of the 1031, but instead of having to find a "like kind" property, you can simply take the proceeds and invest them with a fund.

When I say this one is a "game changer," holy moly. That doesn't begin to describe it.

How it works

Let's say you have $250,000 to invest. Instead of having to find one property under a strict deadline, you could spread that $250,000 into 10 mega funds, giving you direct access to -- and ownership in! -- huge deals, while collecting 15-plus percent annual returns.

Related: 8 Smart Strategies to Help You Invest in Real Estate

In other words, in your portfolio -- yes, yours -- you could own a piece of a high rise, a downtown office building, a 100-plus unit apartment complex and more.

Let's break it down.

1031 vs. 721: How the 721 can protect you

OK, so as awesome as the 1031 is, there are a few drawbacks. For one, you have a limited time period to find a new property, which could leave you in a vulnerable position from a negotiation standpoint. (A seasoned seller will smell this a mile away.)

You might not have a property available that fits your investment strategy, forcing you to either a) pay taxes, b) buy a less than stellar deal or c) overpay for one that does.

The fund hack: Diversification and high returns

Here's where investment funds come in.

They're widely available, many of them open-ended (meaning you can buy in tomorrow, next year, whenever) and you're not under the same pressure to find the perfect property.

In the past, private equity funds were generally closed to "accredited investors," a subsector of affluent investors who -- perceiveably -- have more money and therefore must be more savvy. Basically it means you have to have a net worth of $1 million (minus your primary residence) or make $200,000 a year for the past two years.

All well and good. In reality, it really just closed off investments to those with money exclusively, allowing them to make more money.

Related: The New Tax Law Has Made It a Great Time to Invest in Real Estate. Here's How to Get the Most From Your Investment.

Real estate securities: The rise of crowdfunding (and how you can take advantage)

OK, so this is going to be a bit of a sidebar to give background on how the market works and how the 721 can help.

Because of this gross limitation, new industries emerge and disrupt. (Cryptocurrency is, supposedly, either the future of money or the biggest bubble since tulips.) On the fundraising side, crowdfunding has emerged as a major piece, allowing anyone to raise money.

And crowdfunding has spread to real estate also, most prominently with offerings from Fundrise, a then-new startup that offered "average investors" a piece of the World Trade Center for just $5,000. What it really did was buy $5 million worth of bonds sold by Larry Silverstein, then re-sold them to smaller investors.

Obviously, this became a national story. Which only brought out several more players joining the party.

Opening the floodgates: Title III of the JOBS Act

However, there was a caveat. The vast majority of crowdfunding offerings still were limited to "accredited investors."

On Nov. 16, 2015, the SEC and Congress -- taking notice of the explosive rise of crowdfunding -- approved Title III of the Jobs Act, which opened the floodgates for solicitation to "non-accredited investors."

I say all this to note that the concept of being an accredited investor isn't a deterrent any longer to get in on institutional-quality assets.

How to get into the deals

A number of players have made it to the crowdfunding marketplace, including startups like Arborcrowd and Crowdstreet -- marketplaces full of 721 Exchange opportunities. Instead of just selling shares to the "average investor," they actually offer a marketplace for people shopping for seasoned real estate investors, developers and funds.

Now this, in my humble opinion, is the biggest hack if you're 721 eligible. These are deals with sponsors (a catch-all term for landlords, developers, operators) that offer access to big deals -- whether on a standalone basis or in a portfolio.

Typically, for established real estate funds, a minimum buy-in starts at $1 million and up. With these marketplaces, a minimum buy-in is a manageable $25,000 to $50,000 -- and you get access to similar deals.

Related: 3 Reasons Why Investing in Real Estate Is Easier Than Ever

Is this safe?

Good question. I can say this: It's growing popular among some of the top developers on the scene.

One of my mentors, who's raised a number of $100 million funds in the past, recognized as one of the most powerful developers in the country, and has bought and operated billions in real estate, recently took to this very platform to raise his latest fund.

This weeds out the rinky-dink landlords, scams and unprovens, and instead ensures you get in on deals that actually deliver returns.

Your $250,000 now becomes ...

So now let's go back to the original premise. You have $250,000 to exchange, that you want to invest tax-free.

Going by the active offerings, let say you spread that $250,00 across 10 $25,000 minimum offerings. Your new portfolio may now include direct ownership in hotels, new developments, self storage and malls.

"You are sharing in a pool of properties [in terms of the REIT's portfolio], not just one," giving the investor diversification, said Louis S. Weller, a principal at Deloitte & Touche LLP's national real-estate tax services group in San Francisco.

In doing so, you've obtained the supreme diversification of a billionaire on every conceivable level imaginable: market, asset class, risk level, investment strategy -- you name it. Everything.

You're now ballin' like the 1 percent.

Sure, you will not own 100 percent of it. But, your money will compound, will work for you, it's locked up (unlike stocks where you can just cash out) and your group can actually take your wealth game to that next level.

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