Part of our pillar guide: 1031 Exchange: The Complete Guide →
At a Glance
| Code section | IRC §721 (non-recognition on contribution to a partnership) |
| Structure | UPREIT — umbrella partnership REIT |
| You give | Real property, or a DST interest that holds it |
| You receive | Operating partnership (OP) units, usually redeemable for REIT shares or cash |
| Your basis in the units | Carryover — the same basis you had in the property (§722) |
| Future 1031 eligibility | Generally none — OP units are not real property |
| Gain is triggered by | Redemption, the REIT selling your property, or a debt shift exceeding basis |
| Step-up at death | Generally yes, on the OP units (§1014) |
| Who decides timing | Largely the REIT, after contribution |
| Reported on | Schedule K-1 from the operating partnership |
Most investors who end up in a 721 exchange did not set out to do one. They did a 1031 exchange into a DST because they were tired of tenants and toilets, and somewhere in the offering documents was a clause that let the sponsor's REIT acquire the property later. Two or three years on, they hold OP units instead of real estate.
That outcome is not bad. For the right investor it is close to ideal: passive, diversified, more liquid, and still eligible for a step-up at death. But it is a different asset with a different tax profile, and several of the protections a 1031 investor relies on no longer apply.
This guide covers how the structure works, what changes the moment you hold OP units, the four places investors get caught, and how to tell whether a 721 is an endgame for you or a premature one.
Chapter 1
What a 721 Exchange Actually Is
Section 721 is not a real estate provision. It is the general rule that contributing property to a partnership in exchange for a partnership interest is not a taxable event. Every LLC that has ever been capitalized with property relies on it. The real estate industry borrowed it to solve a specific problem: how a REIT can buy property from an owner with a large built-in gain without forcing that owner to pay the tax.
How the UPREIT is built
A REIT is a corporation for tax purposes, so contributing property to the REIT directly would generally be taxable. The UPREIT solves this by holding the real estate one level down, in an operating partnership. The REIT owns most of the OP. Property owners contribute to the OP, not the REIT, and receive OP units alongside the REIT as fellow partners.
You contribute the property
Real property, or the DST that holds it, moves into the REIT's operating partnership. No cash changes hands, or very little.
You receive OP units
Units are typically designed to track the value and distributions of one REIT share each. Your tax basis in them is your old basis in the property.
You hold — or redeem
After a lockup, often one year, units can usually be presented for redemption. The REIT generally chooses whether to pay in shares or cash. Either way, redemption is taxable.
Where your deferred gain goes
Two rules carry the gain forward. Under §722, your basis in the OP units equals your basis in the property you contributed. Under §704(c), the partnership tracks the gap between the property's value and its tax basis at contribution — the built-in gain — and allocates that gain back to you if the property is ever sold. Nothing was forgiven. The gain moved from a deed to a unit.
A Detail Worth Catching
§704(c) also affects your depreciation. Because the property arrives with a low tax basis, the partnership has less depreciation to allocate, and under most allocation methods the contributing partner absorbs that shortfall. The units can produce more taxable income per dollar of distribution than the same REIT's shares. Ask how the OP allocates §704(c) items before you contribute, not after.
Chapter 2
The DST-to-REIT Path
Very few individual investors negotiate a direct UPREIT contribution. Most 721 exchanges today arrive through a two-step program offered by REIT sponsors:
Step one: a 1031 exchange into a DST
You sell your property and buy a beneficial interest in a Delaware Statutory Trust sponsored by the REIT or an affiliate. Under Rev. Rul. 2004-86, a properly structured DST interest is treated as a direct interest in real property, so this step is a valid 1031 exchange.
Step two: the REIT acquires the DST through §721
After a holding period — commonly two years or more — the operating partnership may exercise an option to acquire the DST property at fair market value, paying DST investors in OP units.
The option usually belongs to the sponsor, not you
In many programs, the investor has no vote on whether the 721 happens or when. The decision that ends your 1031 eligibility may already have been made in the offering documents you signed at step one.
There is a quieter technical issue as well. A 1031 exchange requires that replacement property be held for investment. When a later 721 contribution is effectively pre-arranged from day one, some practitioners consider whether that intent is undermined. Sponsors generally address this with holding periods and by keeping the option discretionary. It is a question for your tax advisor, and it is the reason the waiting period exists.
Read This Before You Buy the DST
If you are evaluating a DST, find the fair market value purchase option in the private placement memorandum. Know who holds it, when it can be exercised, how value is determined, and whether you can elect cash or a different outcome. That paragraph decides your exit more than any return projection in the deck.
Chapter 3
What You Give Up: The One-Way Door
The marketing case for a 721 is liquidity and diversification, and both are real. What is less often written down is the list of things a 1031 investor owns that an OP unitholder does not.
What you gain
- Diversification. One building becomes a slice of a portfolio, often across markets and property types.
- Divisibility. Units can be redeemed in tranches, gifted, or split among heirs far more easily than a deed.
- A path to liquidity. Redemption for REIT shares or cash, subject to the program's limits.
- No management. No lender negotiations, no replacement-property search, no 45-day clock.
What you give up
- Future 1031 exchanges. A partnership interest is not real property. The chain ends here.
- Control over the tax event. The REIT decides when to sell your contributed property and whether to honor redemptions.
- Fresh depreciation. A 1031 into a new asset with cost segregation can restart meaningful deductions. OP units inherit a low basis.
- Leverage on your terms. You can no longer refinance your own asset to pull out tax-free capital.
The first item in the right-hand column is the one that matters most. A 1031 exchange can be repeated for as long as you live, and every repetition is another chance to reposition, re-lever, and restart depreciation. A 721 trades that open-ended optionality for a single, permanent holding. The tax is still deferred — but the only remaining ways to resolve it are to pay it or to die holding the units.
Chapter 4
The Four Tax Traps
Section 721 itself is simple. The exposure lives in the rules around it. These are the four that most often turn a tax-deferred contribution into a partly taxable one.
The debt shift (§752)
If your property carries a mortgage, the partnership takes it over. Your share of partnership liabilities is then recalculated, and if it is smaller than the debt you were relieved of, the difference is treated as a cash distribution. A deemed distribution larger than your basis in the units is taxable gain. Highly leveraged, low-basis properties are the most exposed. Sponsors sometimes address this with debt allocations or guarantee arrangements, which have their own rules.
The disguised sale (§707)
Cash or other property you receive in connection with the contribution can recharacterize part of it as a taxable sale. Under Treas. Reg. §1.707-3, transfers within two years of the contribution are presumed to be part of a sale unless the facts show otherwise. Taking "a little cash out" at closing is the single fastest way to make part of a 721 taxable.
The REIT sells your property
Under §704(c), the built-in gain on your contributed property is allocated to you if the operating partnership sells it — even though you did nothing. Large contributors sometimes negotiate a tax protection agreement, under which the REIT agrees not to sell for a period or to compensate for the tax. Individual DST investors rarely have one. Ask.
Redemption limits and gating
Redemption is the liquidity the structure promises. At listed REITs, units typically convert to freely traded shares. At non-traded REITs, redemption programs are usually capped as a percentage of value per month or quarter and can be limited or suspended; several large non-traded REITs restricted redemptions in 2022 and 2023. The tax bill on a redemption you planned is fixed. The redemption itself may not be.
Chapter 5
A Worked Example: Three Ways the Units End
Consider an investor who has carried a property through several 1031 exchanges and now holds a DST interest worth $3,000,000 with an adjusted basis of $1,000,000. Of the $2,000,000 deferred gain, $800,000 represents prior depreciation. There is no debt, so the §752 trap does not apply. The REIT acquires the DST through a 721 exchange, and the investor receives $3,000,000 of OP units with a $1,000,000 basis.
$3,000,000 of OP Units · $1,000,000 Basis · $2,000,000 Deferred Gain
Ending A — Redeem everything in one year
The full $2,000,000 is recognized. Roughly $516,000 of federal tax comes due, and the proceeds cannot go into another 1031 exchange. This is the outcome the original 1031 chain was built to avoid.
Ending B — Redeem in tranches
Redeeming a quarter of the units each year recognizes about $500,000 of gain annually instead of $2,000,000 at once. At top brackets the rate is similar, but spreading recognition can keep more of it in lower brackets in lower-income years, and it lets the investor take only the liquidity actually needed.
Ending C — Hold until death
Under §1014, the heirs' basis in the units steps up to fair market value. If they redeem soon after, there is little or no gain. The $516,000 is not deferred — it is generally eliminated. Meanwhile the units are easy to divide among several heirs, which a single building is not.
* Hypothetical and illustrative only — not a projection or a representation of any actual or expected result. Assumes top federal rates, that gain is net investment income subject to the 3.8% NIIT, no state tax, no debt, no §704(c) sale by the REIT during the hold, and that redemption gain retains its unrecaptured §1250 character proportionately. Actual character and timing of gain on redemption of partnership units depends on the partnership agreement and the investor's facts. Consult your own CPA or tax attorney.
The example makes the decision clearer than any rule of thumb. If Ending C is the plan, the 721 is an excellent tool. If the investor expects to need the capital in Ending A, they would generally have been better off keeping real property and the option to exchange again. For the full math behind Ending C, see the step-up in basis guide; for the 25% and 3.8% layers, see depreciation recapture and the NIIT.
Chapter 6
721 vs. 1031: Side by Side
| 1031 Exchange | 721 Exchange | |
|---|---|---|
| You receive | Replacement real property | OP units (partnership interest) |
| Repeatable? | Yes, indefinitely | Generally the last deferral step |
| Deadlines | 45-day identification, 180-day close | None imposed by statute |
| Fresh depreciation | Yes, on new basis above carryover | No — carryover basis, §704(c) drag |
| Who controls the tax event | You | Largely the REIT |
| Liquidity | Sale of the property | Redemption, subject to program limits |
| Diversification | One or a few properties | Portfolio-level |
| Step-up at death | Yes | Yes |
| Best for | Investors still building and repositioning | Investors planning to hold until the estate |
The two are not really competitors. They are stages. A 1031 is a tool for the accumulation years, when repositioning and new depreciation still compound. A 721 is a tool for the distribution years, when simplicity, divisibility, and the step-up matter more than optionality. The error is reaching for the second while still in the first. For how 1031 deferral and the step-up work together over a lifetime, see 1031 vs. step-up in basis.
Due Diligence
Questions to Ask Before You Contribute
Who holds the 721 option, and when can it be exercised?
In DST programs, this is usually in the PPM. Know whether you have any say in the timing or form of consideration.
Is the REIT listed or non-traded?
Listed REIT units generally redeem into freely traded shares. Non-traded REIT redemptions are capped and can be suspended.
How is value set at contribution?
Your OP unit count depends on the property valuation and the unit price on that date. Ask who appraises and how the unit price is set.
Is there a tax protection agreement?
If not, the REIT can sell your contributed property and allocate your built-in gain to you at any time.
How will my share of debt be allocated?
If you contribute leveraged property, ask for the §752 analysis in writing before closing.
Which §704(c) method does the OP use?
The method affects how much depreciation reaches you, and therefore how much of each distribution is taxable.
What is the lockup and redemption process?
Know the minimum hold, the notice period, any caps, and whether the REIT chooses between shares and cash.
FAQ
Frequently Asked Questions
What is a 721 exchange?
A 721 exchange is a contribution of property to a partnership in exchange for an interest in that partnership, which IRC §721 generally treats as a non-taxable event. In real estate, the term almost always means contributing a property — or a DST interest — to the operating partnership of a REIT in exchange for operating partnership (OP) units. The structure is called an UPREIT, for umbrella partnership REIT. Your deferred gain carries over into the OP units rather than being recognized.
Is a 721 exchange the same as a 1031 exchange?
No. A 1031 exchange swaps real property for other like-kind real property and can be repeated indefinitely. A 721 exchange swaps real property for a partnership interest. Both defer gain, but OP units are not real property, so once you complete a 721 exchange you generally cannot do another 1031 exchange with that capital. The 721 is often the last deferral step, not the next one in a chain.
Can I do a 1031 exchange after a 721 exchange?
Generally not with the OP units. Since 2018, §1031 applies only to real property, and a partnership interest is not real property. If you later redeem your OP units for REIT shares or cash, that redemption is a taxable event, and the proceeds cannot be rolled into a new 1031 exchange.
When do I pay tax after a 721 exchange?
Typically when you redeem OP units for REIT shares or cash, when the operating partnership sells the property you contributed (unless a tax protection agreement covers it), or when a reduction in your share of partnership debt is treated as a cash distribution that exceeds your basis. Redemption recognizes the gain deferred into the units, including the depreciation recapture component, in proportion to the units redeemed.
Do OP units get a step-up in basis at death?
Generally yes. OP units are a capital asset held by you, so under IRC §1014 your heirs typically receive a basis equal to fair market value at your death. They can then redeem the units with little or no gain. This is the main reason the UPREIT has been used as an estate-planning exit: it converts a concentrated property into a more divisible, more liquid holding without ending the deferral before death.
How does the DST-to-REIT 721 path work?
An investor completes a 1031 exchange into a Delaware Statutory Trust sponsored by a REIT or its affiliate. A beneficial interest in a qualifying DST is treated as a direct interest in real property for 1031 purposes under Rev. Rul. 2004-86. After a holding period — often two years or more — the REIT's operating partnership may acquire the DST property through a 721 contribution, and the DST investors receive OP units. Whether and when that happens is usually at the sponsor's option, not the investor's.
What are the biggest risks of a 721 exchange?
The four most common are: losing the ability to do future 1031 exchanges; losing control over when gain is recognized, because the REIT decides when to sell the property and when to honor redemptions; a §752 deemed distribution if the debt you were carrying is not fully reallocated to you inside the partnership; and limited liquidity, since redemption programs at non-traded REITs can be capped or suspended.
Continue Learning
1031 Exchange Guide
The repeatable deferral that a 721 ends — rules, deadlines, and how to keep the chain going.
Delaware Statutory Trusts (DSTs)
The passive 1031 replacement that most 721 exchanges pass through. What to read in the PPM.
Step-Up in Basis at Death
Why OP units held until death can eliminate the deferred gain rather than just delay it.
1031 vs. Step-Up in Basis
How lifetime deferral and the estate reset work together — the frame a 721 decision belongs in.
Depreciation Recapture
The 25% layer embedded in your OP units, and what comes due when you redeem.
NIIT & Real Estate
The 3.8% surtax that stacks on top of redemption gain for passive investors.