What a 721 exchange is
Section 721 of the Internal Revenue Code generally allows a person to contribute property to a partnership in exchange for a partnership interest without recognizing gain. Real estate investment trusts use this rule through a structure called an UPREIT — an umbrella partnership REIT — in which the REIT owns its properties through an operating partnership.
In a 721 exchange, a property owner contributes real estate, or an interest in it, to the operating partnership and receives operating partnership units in return. OP units are designed to track the value and distributions of the REIT’s shares, and they can usually be converted into REIT shares or cash later. The tax on the property’s built-in gain is deferred until that conversion or another taxable event.
How it differs from a 1031 exchange
A 1031 exchange swaps one piece of real estate for another. A 721 exchange swaps real estate for a partnership interest in a real estate company. That difference drives most of the pros and cons.
- After a 1031, you still own real property and can exchange again. After a 721, you own OP units, which are not real estate for 1031 purposes, so further 1031 exchanges are generally no longer available.
- A 1031 has strict 45-day and 180-day deadlines. A 721 contribution is negotiated directly with the REIT and does not use those identification windows.
- A 1031 keeps you concentrated in the properties you choose. A 721 typically gives you an interest in a large, diversified portfolio managed by the REIT.
- Converting OP units to REIT shares or cash is generally a taxable event, so investors control the timing of tax by deciding when, and how many units, to convert.
The DST-to-721 path
Most REITs will not accept a single small apartment building directly. A common route is two steps. First, an owner sells their building and completes a 1031 exchange into a Delaware statutory trust sponsored by, or affiliated with, a REIT. Later, often after a required holding period, the REIT may offer to acquire the DST property through a 721 exchange, giving DST investors OP units instead of a cash sale.
This lets an owner defer the gain at the original sale, collect DST income for a period and then move into a diversified REIT interest, still without paying tax. Investors should read the offering documents closely: some programs give the REIT the option, not the obligation, to complete the 721, and some leave investors few alternatives once the option is exercised.
Why owners consider it
For owners who are done with direct ownership but not ready to pay the tax bill, a 721 can solve several problems at once.
- Diversification: one building becomes a small share of a larger portfolio across properties and markets.
- Liquidity over time: OP units can typically be converted into shares that trade or can be redeemed, which can be more flexible than waiting for a single property to sell.
- Control over tax timing: converting units in smaller amounts over several years can spread out gain recognition.
- Estate planning: OP units held until death may receive a step-up in basis under current law, potentially eliminating the deferred gain for heirs.
- No more management: there are no tenants, repairs or refinances to handle.
The trade-offs
The biggest drawback is that the move is usually permanent from a 1031 perspective. Once your equity is in OP units, you generally cannot exchange back into direct real estate without recognizing gain. You also give up control of what you own, how it is financed and when it is sold.
Other considerations include REIT fees and governance, the market value of the shares that OP units track, restrictions on when units can be redeemed, and the possibility that the REIT sells the property you contributed. Some contribution agreements include tax protection provisions that limit such sales for a period; many do not. Have a tax advisor model the deferred gain, the conversion plan and the estate implications before agreeing to a 721.
Who a 721 exchange tends to suit
It tends to suit long-time owners with a low tax basis and a large built-in gain who want income and diversification, value a potential step-up for their heirs and are comfortable no longer controlling individual properties. It suits less well investors who want to keep growing a portfolio through future 1031 exchanges, or who want to pick their own markets and business plans.
If you are weighing a 721 against selling your building to a private buyer, compare the after-tax result of each path over the period you care about, including fees, expected distributions and the flexibility you give up.
