The UPREIT 721 Exchange (Section 721 Contribution)

How it works

Section 721(a) provides that no gain or loss is recognized to a partnership, or to any of its partners, on a contribution of property to the partnership in exchange for an interest in the partnership. No control requirement, no percentage test, no holding period, no deadline. A landlord contributes a building, the partnership issues units, and nobody recognizes gain.

The market calls this a 721 exchange, and the name misleads. It is not an exchange, and nothing in section 1031 applies to it: no forty-five-day identification, no one-hundred-eighty-day clock, no qualified intermediary, no like-kind test. It is a contribution to a partnership, and its rulebook carries three regimes section 1031 does not have at all: disguised sales under section 707(a)(2)(B), liability shifts under sections 752 and 731, and built-in gain tracking under section 704(c).

The partnership exists for a structural reason. A REIT is a corporation, and a contribution of property straight to the REIT for shares is tested under section 351, where it fails twice: section 351(a) requires the transferors to control the corporation immediately afterward, which one contributing landlord never does, and independently section 351(e)(1) denies section 351 for a transfer to an investment company, with Treasury Regulation 1.351-1(c)(1)(ii)(b) naming a real estate investment trust as an investment-company transferee outright. The umbrella partnership is the answer. The REIT holds the controlling general-partner interest in an operating partnership, that partnership holds the buildings, and the contribution goes there, where section 721 has neither obstacle.

What the contributor holds afterward is OP units: a limited-partner-style interest paying a distribution per unit that tracks the REIT's dividend per share, with a contractual right after a lockup to tender the units for cash or, at the REIT's election, for REIT shares. Redemption or conversion is the taxable event the structure was built to postpone.

The Florida layer

Florida has no individual income tax and does not tax pass-through income at the personal level, so the income-tax question is entirely federal: long-term capital gain, the unrecaptured section 1250 layer underneath it, and the net investment income tax. What Florida taxes is the deed. A section 721 contribution is executed by a deed conveying fee title to the operating partnership, and Fla. Stat. 201.02(1)(a) taxes that deed at 70 cents per $100 of consideration, a rate the Department of Revenue administers differently in Miami-Dade County. No federal tax at closing is not the same sentence as no tax at closing.

Who this applies to

Section 721 imposes no eligibility test on the contributor at all, so the filtering here is economic rather than statutory, and it is unusually sharp.

• The owner this was built for. Appreciated real property with an adjusted basis near land value, usually because the building is fully depreciated, usually carrying an old mortgage, held by someone who wants income without management and expects to hold whatever they receive for life.
• The operating partnership on the other side. Not every one works, and the test runs on its balance sheet rather than its brochure.
• Who should not sign. Anyone who might need the cash, who wants to keep the option to exchange again, or whose remaining horizon is shorter than the lock-out the sponsor is asking for. The contribution ends the optionality permanently.

Not everyone arrives here from a building. Many Delaware statutory trust sponsors offer a section 721 contribution of the trust interest into their own REIT's operating partnership at the trust's mandatory disposition, so an investor who chose a DST as 1031 replacement property can find this decision waiting at the end of it.

What it requires

The section 721(b) investment-company gate

Section 721(b) turns off nonrecognition for gain realized on a transfer of property to a partnership that would be treated as an investment company, within the meaning of section 351, if the partnership were incorporated. No Treasury regulation has ever been issued under section 721(b), so the analysis runs through section 351 and Treasury Regulation 1.351-1(c), a two-prong test on which both prongs are required. Diversification, the first, is almost always present. What saves an ordinary contribution is that the second prong is not met: hypothetically incorporate the operating partnership and it owns buildings, which are not readily marketable stocks or securities, so it is not the transferee that prong describes. Run that test against the statute's list rather than the regulation's, because section 351(e)(1) counts money as stock and securities while the regulation excludes cash from its computation, and where they conflict the Code governs. That difference keeps this gate live for a newly formed partnership sitting on undeployed offering proceeds, for one holding interests in other entities rather than buildings, and for a mortgage REIT's partnership.

The disguised-sale rules

Section 707(a)(2)(B) is the anti-abuse companion to section 721: where a partner transfers property to a partnership, the partnership transfers money or other property back to that partner, and the two viewed together are properly characterized as a sale, they are treated as one. Two regulatory presumptions point in opposite directions. Transfers within two years of each other, in either order, are presumed to be a sale unless the facts and circumstances clearly establish that they are not. Transfers more than two years apart are presumed not to be a sale unless the facts and circumstances clearly establish that they are. Both are rebuttable, the two-year window is the one that bites, and neither presumption is the test: the standard underneath is facts and circumstances, supported by a ten-factor list.

The mortgage, which is where deals actually break

The debt raises two separate questions. The first is whether the mortgage is a qualified liability. One incurred more than two years before the earlier of the written transfer agreement or the transfer, and encumbering the property throughout that period, qualifies; so does one incurred inside that window but not in anticipation of the transfer, that has encumbered the property since it was incurred. If it is not qualified, the partnership is treated as transferring consideration to the partner to the extent the liability exceeds the partner's share of it immediately after the assumption, and that consideration is disguised-sale proceeds.

A liability incurred within two years of the transfer, or of the written agreement to transfer, is presumed to have been incurred in anticipation of it, rebuttable only on facts and circumstances clearly establishing otherwise. The parenthetical in that rule does real work: the presumption does not reach a liability traceable to capital expenditures on the property, or an ordinary-course trade or business liability. Nor does a rate-and-term refinance restart the clock, since to the extent a new loan's proceeds are allocable to discharging an existing liability the refinancing debt is treated as that existing liability, keeping its incurrence date and its history of encumbering the property. Only the cash-out increment stands on its own. The rule is not never refinance; it is keep it rate-and-term, trace the proceeds, and treat the money taken out, and only that, as exposed.

The second question applies even where there is no disguised sale. Any decrease in a partner's share of partnership liabilities, and any decrease in a partner's individual liabilities by reason of the partnership assuming them, is treated as a distribution of money, and gain is recognized to the extent that money exceeds the adjusted basis of the partner's interest immediately before it. A contributor relieved of an entire mortgage who takes back only a share of it therefore has a net deemed cash distribution, measured against an outside basis that carries over from the property and so sits near land value on a fully depreciated building. What rescues the arithmetic is the second of the three tiers by which nonrecourse liabilities are allocated: the gain that would be allocated to that partner under section 704(c) if the partnership disposed of all property subject to nonrecourse liabilities in full satisfaction of them and for no other consideration. It hands a low-basis contributor back a share of the debt measured by the mortgage less adjusted basis. The third tier, the excess, is shared by whichever method the partnership agreement adopts.

The two regimes do not share that rescue, and this is the point most consistently understated in write-ups of the structure. For disguised-sale purposes a partner's share of a nonrecourse liability is the same percentage used for that partner's share of the excess under the third tier, and the third tier's own text turns off the significant-item, alternative and additional methods for that purpose. Only the bare profit-share percentage travels, and the first two tiers never enter the computation at all. The same mortgage, on the same day, produces one share for the section 731 question and a far smaller one for the section 707 question. That is why a non-qualified liability is a catastrophe and a qualified one is a non-event: the qualified-liability analysis does all the work, and the liability-allocation machinery is not a backstop for it.

The Florida deed

Consideration for the documentary stamp tax expressly includes the amount of any mortgage or other encumbrance, whether or not the underlying indebtedness is assumed, and where the consideration includes property other than money it is presumed equal to the fair market value of the real property. OP units are property other than money, and Florida has appellate authority on the pattern: in Muben-Lamar the court affirmed the tax on a contribution of land to a limited partnership, holding that the partnership bought the real property by issuing valuable partnership interests for it. Crescent Miami Center, the case usually cited the other way, holds only that a transfer between a grantor and its wholly owned grantee, absent any exchange of value, is without consideration or a purchaser, and a contribution to an unrelated public REIT's operating partnership is the opposite on both elements.

What you need to document

The operating partnership's asset representation

A written representation as to the composition of its assets on the closing date, tested against the statutory list in section 351(e)(1) rather than the regulation's shorter one, and specifically including cash. A failure here is not a partial problem; it recognizes the entire realized gain.

Tracing for any refinance

Records showing how much of a refinancing's proceeds discharged the old loan and how much came out as cash, papered at the time rather than reconstructed at closing.

The liability model, before signing

The contributed property's adjusted basis, the three-tier nonrecourse allocation, the netting of the increase and the decrease arising out of the same transaction, and the resulting gain if any. Its absence surfaces on the next Schedule K-1, which reports the partner's share of net unrecognized section 704(c) gain at the beginning and end of each year.

The tax protection agreement

The lock-out covenant, meaning how long the partnership agrees not to dispose of the contributed property taxably, and the debt-maintenance covenant, meaning how much qualifying nonrecourse debt it agrees to keep on the property. Whether a make-whole is grossed up for the tax on the make-whole itself, and who owes it, are negotiated terms rather than boilerplate.

A written answer on the section 754 election

Whether the operating partnership has one in effect. For a client whose plan is to hold to death this is the most consequential question on the list, and it is the one nobody asks.

Where it goes wrong

• Nobody modeled the liability shift. The most common failure and the most expensive one. The symptom is a client presenting a Schedule K-1 the year after a supposedly tax-free contribution, showing a large gain nobody warned them about.
• A cash-out refinance inside the two-year window. The failure is the money taken out, not the refinancing, and because the disguised-sale computation gives the contributor only a profit share of that liability, essentially the whole increment lands as proceeds.
• A seven-year trip. If the contributed property goes to a partner other than the contributor within seven years, the contributor recognizes the built-in gain that would have been allocated on a sale at the distribution-date value. If instead the partnership distributes other property, money aside, to the contributor within seven years, the contributor recognizes the lesser of the excess of that property's value over outside basis, or the net precontribution gain.
• A lock-out that expires quietly, or debt that amortizes away. The partnership sells the building in year eight and the full built-in gain lands on the contributor with no cash to pay it. Short of that, every reduction in the mortgage shrinks the second-tier share, and each shrinkage is another deemed cash distribution in a year with nothing else happening.
• A passive interest that frees nothing. OP units are passive under section 469, because the holder participates in nothing. A client relying on real estate professional status or the short-term rental treatment for active-income offset loses that tool the moment the property leaves their hands, and the contribution does not release suspended losses either: section 469(g)(1)(A) frees them only on a fully taxable disposition of the entire interest in the activity, and a nonrecognition contribution is neither.

The exit is always taxable, and the buyer's identity changes the rules

Read the redemption clause before naming a Code section. If the REIT or another partner acquires the tendered units, that is a sale or exchange of a partnership interest, recognized by the transferor and capital except as section 751 provides, measured against a carried-over basis usually close to zero. If the operating partnership itself acquires them, that is a redemption, governed instead by the rules on partnership distributions and on payments in liquidation of a retiring partner's interest. Converting units into REIT shares is taxable on either route: where the partnership distributes the shares, marketable securities count as money at fair market value for this purpose, so they produce gain to the extent they exceed outside basis. There is no non-recognition path from OP units into publicly traded shares.

The character on exit is not uniformly a 20 percent capital gain either. Section 751 pulls section 1245 and section 1250 property into unrealized receivables here, to the extent of the recapture that would arise on a sale at fair market value, and that slice is ordinary income. For a building depreciated straight-line the section 1250 recapture is generally nil, but on a property that has been through a cost segregation study the section 1245 piece is real. The capital-gain look-through regulation then carries section 1250 capital gain through to the sale of the interest, so selling OP units does not escape the unrecaptured section 1250 layer built up on the building. Both look-through paragraphs switch off on a redemption, which is not a discount: the hot-asset rules reach a distribution too.

In, maybe. Out, never.

Property may be able to move into a section 721 contribution, but the authority is thinner than it is usually made to sound. Magneson v. Commissioner held that property acquired in a like-kind exchange and contributed to a partnership the same day was still held for investment under section 1031(a), and the court limited its holding, in terms, to a contribution for a general partnership interest, which an OP unit is not. It distinguished the Service's contrary ruling, Rev. Rul. 75-292, on the ground that a shareholder neither owns the corporation's assets nor participates in management while a general partner does both, and an OP unit holder owns no specific partnership property and manages nothing, which puts an OP contribution on the ruling's side of that line. Magneson is Ninth Circuit authority, persuasive only in Florida, and the Service has published nothing blessing a section 1031 exchange followed by a contribution to a REIT operating partnership. Treat that sequence as unsettled, with the weight of the authority running against it.

The other direction is not unsettled at all. Section 1031 reaches real property held for productive use in a trade or business or for investment. An OP unit is an interest in a partnership rather than real property, so it can never be exchanged under section 1031. The pre-2018 statute excluded partnership interests expressly; the 2017 Act collapsed that provision, and partnership interests now fail simply because they are not real property. The one statutory bypass treats an interest in a partnership that has validly elected out of Subchapter K as an interest in each of the partnership's assets, and an operating REIT partnership has not made that election and structurally cannot.

Direct real property, and a compliant Delaware statutory trust interest, can be exchanged again and again, and each hold ends with a fresh choice. OP units end the optionality. From the moment the contribution closes there are two doors: hold to death for a basis step-up, or a taxable exit. There is no third door. A client should hear that sentence out loud before signing, and it belongs in the engagement file.

What the step-up actually reaches

A partnership interest is property acquired from a decedent, so outside basis steps up to the interest's date-of-death or alternate-valuation-date fair market value, increased by the successor's share of partnership liabilities and reduced to the extent that value is attributable to income in respect of a decedent. What does not follow automatically is the inside basis. The step-up is to the interest, not to the partnership's basis in the building, and section 704(c)(3) carries the deferred gain past the funeral by treating a reference to the contributing partner as including a reference to any successor of that partner, so the heir inherits the contributor's built-in gain layer. What neutralizes it is a section 754 election: partnership property basis is adjusted on the death of a partner only if that election is in effect, and where it is, the resulting adjustment absorbs the inherited gain. Without one, the heir still takes a stepped-up outside basis but will be allocated the decedent's built-in gain when the partnership eventually sells the building. Large public operating partnerships generally do have an election in effect. Generally is not a fact, and it is a question to ask in writing before recommending a plan built on holding to death.

A situation where this comes up

The version I see most often is a couple in their seventies with a Central Florida commercial building bought in the 1990s, fully depreciated, carrying a mortgage placed years ago, with an adjusted basis that is essentially the land. They want the income without the roof, and a sponsor has put an offer in front of them describing the contribution as tax-free. It can be. Whether it is turns on the age and history of that mortgage, on the allocation method written into the partnership agreement, and on what the partnership's balance sheet holds at closing, none of which appear in a brochure. The questions that decide it are all answerable before anyone signs, and all of them get answered by someone other than the client.