721 Exchanges: The Details Matter

IRC Section 721(a) states that no gain or loss is recognized by a partnership or its partners when property is contributed to the partnership in exchange for an interest in that partnership. This is the core of what’s often called a "721 exchange." It’s a mechanism that allows investors to transfer property—like real estate—into a partnership without triggering an immediate tax event, deferring capital gains taxes that would otherwise hit if the property were sold outright. Think of it as a way to shift from owning a single asset to holding a stake in a broader entity, all while keeping Uncle Sam at bay for a bit longer.

A common real-world application is the UPREIT structure—Umbrella Partnership Real Estate Investment Trust. Here’s how it typically works: a property owner contributes real estate to the operating partnership (OP) of a REIT in exchange for OP units, which are essentially partnership interests. These units can later be converted into REIT shares, often publicly traded, offering liquidity and diversification. The tax on the gain is deferred until those units are sold or redeemed, which could be years down the line. For example, if you’ve got a commercial property with a low basis and big appreciation—say, bought for $500,000 and now worth $2 million—you could contribute it to an UPREIT, avoid paying tax on that $1.5 million gain for now, and instead get units tied to a diversified portfolio of properties.

There are some wrinkles, though. Section 721(b) throws in a caveat: if the partnership would be treated as an investment company (like under IRC Section 351) if it were a corporation, the nonrecognition rule doesn’t apply. This prevents using 721 to dodge taxes by dumping property into what’s essentially a mutual fund masquerading as a partnership. Also, Section 721(c) gives the Treasury authority to issue regulations that could nix the tax deferral if the gain would end up taxed to a non-U.S. person—think foreign investors or complex international setups.

Why might someone use this? Beyond tax deferral, it’s about flexibility. Unlike a 1031 exchange, which requires swapping one property for another of "like-kind" within tight timelines, a 721 exchange lets you trade into a partnership interest without hunting for a replacement property. It’s a big deal for estate planning too—OP units can get a step-up in basis at death, potentially wiping out deferred gains for heirs under current law. Plus, you’re offloading management headaches to the REIT while gaining exposure to a broader asset pool.

Exchanges involve complex rules and regulations that require careful planning and attention to detail. Whether you are looking to reinvest in like-kind properties or transition into passive investment vehicles like REITs, it’s crucial to seek guidance from experienced real estate, legal, and tax professionals to ensure that you fully understand the implications of each strategy. Proceeding with caution is essential, as even small missteps in timing, property eligibility, or compliance could result in unintended tax liabilities. By working with the right professionals, you can make informed decisions that align with your long-term investment goals while minimizing risks. 721ce.com is an excellent resource to reach out to for such assistance.

721ce, LLC does not provide legal, tax, or accounting advice.  You should consult with your own professional before engaging in any transaction. Examples are for illustrative purposes only and do not apply to other experiences.