What Is a 721 Exchange?

Many real estate owners would like to sell their property and stop dealing with tenants, repairs, bills, and everyday management. However, selling an appreciated property may create a large capital-gains tax bill.

A 721 exchange may provide another option.

The Simple Explanation

A 721 exchange allows a property owner to contribute real estate to a partnership in return for an ownership interest in that partnership.

Instead of receiving cash for the property, the owner receives partnership units.

Because the owner exchanged property for an interest in the partnership, taxes on the gain may be deferred. In simple terms, the government generally does not treat the contribution as a regular sale at that time.

Section 721 of the Internal Revenue Code states that gain or loss is generally not recognized when property is contributed to a partnership in exchange for an interest in that partnership.

When Did the 721 Exchange Begin?

Section 721 became part of the Internal Revenue Code of 1954, which was signed into law on August 16, 1954.

The law was created to allow people to place property into a partnership without immediately creating a taxable event. It can apply when a new partnership is formed or when property is contributed to a partnership that is already operating. Although Section 721 has existed for many years, it has become especially important in the real estate world because of structures commonly called UPREITs.

What Is an UPREIT?

UPREIT stands for Umbrella Partnership Real Estate Investment Trust.

That sounds complicated, but the basic idea is simple:

A real estate investment trust, or REIT, operates through a partnership. A property owner contributes real estate to that operating partnership and receives partnership units in return.

The owner no longer directly owns the original building. Instead, the owner has an interest in a larger partnership that may own many properties.

A Simple Example

Imagine that Susan owns an apartment building worth $2 million.

She purchased it many years ago for much less, so selling it today could create a large taxable gain. She is also tired of handling repairs, tenants, insurance, and property management.

Through a properly structured 721 exchange, Susan contributes her apartment building to the operating partnership of a REIT.

In return, she receives operating-partnership units.

Susan has changed from being the direct owner of one apartment building into an investor in a partnership that may own many different properties. Her taxable gain is generally deferred at the time of the contribution rather than erased.

Why Would Someone Consider a 721 Exchange?

A property owner may consider a 721 exchange for several reasons:

• To defer capital-gains taxes

• To reduce the responsibilities of directly managing real estate

• To move from one property into an interest connected to a larger portfolio

• To receive potential income from professionally managed properties

• To improve diversification

• To simplify the transfer of wealth to family members

Diversification does not guarantee a profit or protect against a loss, but owning an interest connected to several properties may reduce the owner’s dependence on one building or one location.

How Is a 721 Exchange Different From a 1031 Exchange?

A 1031 exchange generally allows an investor to sell investment real estate and purchase other qualifying real estate while deferring taxes.

A 721 exchange involves contributing property to a partnership and receiving partnership units instead of another individually owned property.

Here is an easy way to remember the difference:

1031 exchange: Real estate is exchanged for other real estate.

721 exchange: Real estate is contributed in exchange for partnership ownership.

Another important difference is that a 1031 exchange normally has strict identification and closing deadlines. A Section 721 contribution does not use the same 45-day identification and 180-day completion rules. However, it has its own legal, tax, and partnership requirements.

Can a 1031 Exchange Lead to a 721 Exchange?

In some programs, an investor may first complete a 1031 exchange into a Delaware Statutory Trust, commonly called a DST.

The investor owns a beneficial interest in the DST, which owns one or more investment properties. At some future point, the DST sponsor may arrange for the property to be contributed to the operating partnership of a REIT under Section 721.

The investor may then receive operating-partnership units.

This is sometimes described as a 1031-to-721 strategy:

Sale of original property → 1031 exchange into a DST → possible later contribution to a REIT operating partnership

The future 721 transaction is not automatic unless it is specifically offered and completed by the sponsor. Investors generally cannot demand that a DST property be converted into operating-partnership units.

Does a 721 Exchange Eliminate Taxes?

No. It usually defers taxes rather than eliminating them.

If the investor later sells the operating-partnership units for cash, the deferred gain may become taxable. A taxable event may also occur if the partnership sells the contributed property or if certain debt and partnership rules are not handled properly.

The details can be complicated, especially when the property has a mortgage. Receiving cash or certain other benefits as part of the transaction can cause some or all of the contribution to be treated as a taxable sale rather than a tax-deferred contribution.

What Are the Possible Drawbacks?

A 721 exchange is not right for everyone.

Possible concerns include:

• Partnership units may not be easily sold.

• The investor gives up direct control of the original property.

• Income and property values are not guaranteed.

• Fees and expenses may apply.

• The investment may be difficult to value.

• Future decisions are generally made by the partnership or REIT.

• Converting units into REIT shares or cash may create taxes.

• Once the property has entered a partnership structure, the investor generally cannot perform another personal 1031 exchange with the partnership units.

Because every property and investor is different, the legal documents, debt, tax basis, income needs, and estate-planning goals should all be carefully reviewed.

The Bottom Line

A 721 exchange can help some real estate owners move from directly owning and managing property to owning an interest in a professionally managed real estate partnership.

It may allow the owner to defer taxes, reduce management responsibilities, and participate in a larger real estate portfolio. However, the investor also gives up control and accepts the risks, rules, expenses, and limitations of the partnership.

A 721 exchange should be carefully coordinated with experienced tax, legal, and financial professionals before any property is transferred.

NOTE: 

This information is provided for educational purposes only and should not be considered individualized tax, legal, or investment advice. Section 721 transactions are complex, and their tax treatment depends on each investor’s individual circumstances.