What Is a 721 Exchange?

What is a 721 exchange? It is a contribution of property to a partnership in return for a partnership interest, commonly units in an operating partnership. Publication 541 says that usually neither the partner nor the partnership recognizes gain or loss when property is contributed for that interest. The rule applies whether the partnership is being formed or is already operating. Real estate sponsors call the partnership-unit version a 721 exchange or an UPREIT contribution. The tax rule is the contribution. The units are the interest you receive.

Illustrations here are not a rate quote and not an offer of credit. An inquiry is not an approval.

What Is a 721 Exchange for Operating Partnership Units

You own a rental. A partnership, often the operating partnership under a real estate investment trust structure, wants the building. You deed the property in. You take back units. You do not take cash as the price of the deed, or the transaction starts to look like a sale. Publication 541’s general rule is nonrecognition on that contribution. The partnership’s holding period for the property includes your holding period. You have swapped control of one asset for a slice of a larger pool, and you have not, under that general rule, cashed out.

The basis follows the property in at your number, not at today’s value. Publication 541 says the partnership’s basis for depreciation, depletion, gain, or loss is the same as your adjusted basis at contribution, increased by any gain you recognize at that moment. If your building is worth more than your remaining basis, the partnership does not start depreciation from market value. The built-in difference is preserved.

That difference has to be allocated back to you. Publication 541 says the fair market value at contribution may differ from your adjusted basis, and the partnership must allocate income, deduction, gain, or loss on the property in a way that accounts for the difference. If the partnership later sells the property, built-in gain or loss is allocated to the contributing partner. Depreciation allocations also take the built-in difference into account. The other partners do not absorb your old gain just because their names are now on the same return. Regulations section 1.704-3, which the publication points to, is the allocation machinery. The operating agreement’s waterfall does not override it.

This is not a like-kind exchange. A 1031 swaps real property for other real property and has its own requirements. A 721 contributes property to a partnership for a partnership interest. People stack the labels because both can postpone gain. The statutes are different, the replacement asset is different, and the thing you own the next morning is different. A 1031 into a rental you will finance is the exchange path. This page is the contribution path. Do not import identification deadlines from one into the other.

A Delaware statutory trust used in a 1031 is a third structure. Under the IRS ruling that supports that path, qualifying trust interests are treated as ownership of the real estate, not as partnership units. Operating-partnership units are partnership interests. If a sponsor offers both, read which security you are buying. The nickname “exchange” is doing too much work if you treat them as the same receipt.

When the Contribution Is Taxable Anyway

Publication 541’s “usually” is doing real work. Gain is recognized when property is contributed to a partnership that would be treated as an investment company if it were incorporated. The publication says a partnership is generally treated as an investment company if over 80 percent of the value of its assets is held for investment and consists of certain readily marketable items. Those items include money, stocks and other equity interests in a corporation, and interests in regulated investment companies and REITs. The test is ordinarily applied immediately after the transfer. A partnership that holds the rental real estate you just contributed is a different asset mix from a fund that is mostly securities and REIT shares. The exception still has to be checked against the actual balance sheet, especially if the operating partnership’s value is tied up in REIT interests rather than in buildings.

A disguised sale is the other trap. Publication 541 says a contribution followed by a distribution of different property is treated as a sale when two tests are met. The distribution would not have been made but for the contribution. And your right to the distribution does not depend on the success of partnership operations. If the contribution and the distribution happen within 2 years of each other, the transfers are presumed to be a sale unless the facts clearly indicate they are not. If they are more than 2 years apart, they are presumed not to be a sale unless the facts clearly indicate they are. Cash out at closing, or a debt-financed distribution timed to the deed, is the pattern this presumption was written for. Units plus a large check is often a part-sale, part-contribution. Model it that way before you sign.

If money or other consideration moves between you and the partnership within 2 years before or after the contribution, Publication 541 says you attach Form 8275, or another statement, with the caption identifying it as a disclosure under section 707, a description of what moved, and the facts that show whether the transfers are a disguised sale. Exceptions sit in Regulations section 1.707-3(c)(2). The form is a disclosure. It is not a cure.

Debt on the property can change the result, because a contribution of an encumbered building shifts liabilities among partners. Publication 541’s nonrecognition rule is the starting point. It is not a computed answer on your note. Have the liability schedule run before you treat the deed as tax-free. This article does not supply that schedule.

What You Own After the Deed

You own a partnership interest. Publication 541’s nonrecognition rule is about receiving that interest for the property. A later sale of the units, or a conversion of operating-partnership units into REIT shares, is a later transaction. Do not assume the later step is covered by section 721. Sponsors describe a path from units to listed shares. The tax result of that path is whatever that exchange or redemption actually is, and it can recognize the gain the contribution postponed. Ask for that step in writing, separate from the contribution opinion.

Control leaves with the deed. The partnership operates, leases, finances, and sells. You have the rights the operating agreement gives a unit holder: distributions, allocations, transfer limits, and whatever governance a minority holder actually has. How a real estate partnership is structured is the document layer. A syndication is the cousin transaction, where you contribute cash to someone else’s property rather than contributing your property for units. A REIT versus a rental you operate is the end state many 721 contributors are walking toward. You are trading a building you can refinance or sell on your own timetable for a security with a different buyer and a different clock.

One more hold period sits inside the partnership. If the partnership distributes the property you contributed to another partner within 7 years of the contribution, Publication 541 says you recognize gain or loss. The amount is the gain or loss you would have recognized if the property had been sold for fair market value when it was distributed, measured as the difference between basis and fair market value at the time of contribution. Character follows a sale to that other partner. Basis in your units and in the distributed property is adjusted for the gain or loss you recognize. You cannot assume the building will sit in the partnership untouched for seven years unless the agreement says something you are willing to rely on.

Services are not property. Publication 541 treats a partnership capital interest received for services as compensation, generally included at fair market value when the interest is transferable or not subject to a substantial risk of forfeiture. If part of your units pay you for finding the deal or managing it, that part is not a 721 contribution of real estate. Split the receipt. Property in one line. Services in another.

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Frequently Asked Questions

What do I receive in a 721 exchange?

A partnership interest, often called operating-partnership units. What is a 721 exchange is a contribution of property for that interest. Publication 541 says neither you nor the partnership usually recognizes gain or loss on the contribution. You do not receive a tax-free cash sale, and you do not receive REIT shares at the contribution step unless a different transaction is happening at the same time.

Does my low basis disappear when the partnership takes the building?

No. The partnership’s basis in the property starts at your adjusted basis, increased by any gain you recognize at contribution. Built-in gain, the gap between that basis and fair market value, is allocated back to you if the property is sold. Depreciation deductions are also allocated in a way that accounts for the built-in difference.

Is a 721 the same as a 1031 or a Delaware statutory trust?

No. A 1031 exchanges real property for like-kind real property, and a qualifying Delaware statutory trust interest under Revenue Ruling 2004-86 is treated as ownership of the underlying real estate. A 721 gives you a partnership interest. Only that contribution is the subject of section 721.

Can I take cash at closing and still defer all the gain?

Often no. Publication 541 presumes a sale when a contribution and a related distribution of other property happen within 2 years, unless the facts clearly show otherwise. Cash that would not have been distributed but for the contribution, and that does not depend on partnership operations, is the disguised-sale pattern. Model any check as a possible taxable sale, then ask what portion, if any, is a clean contribution.

What happens if the partnership gives my building to someone else?

If that distribution to another partner happens within 7 years of your contribution, Publication 541 says you recognize the built-in gain or loss, measured from basis and fair market value at the contribution. The character matches a sale of that property to the partner who receives it. Your unit basis is adjusted for the gain or loss you recognize.