Most real estate investors know the 1031 exchange — trading one investment property for another to defer tax. Fewer know its cousin, the 721 exchange, which lets you convert your property into ownership in a real estate investment trust (REIT), tax-deferred. Named for Section 721 of the Internal Revenue Code, a 721 exchange involves contributing your property to a REIT's operating partnership in exchange for partnership units (often called 'OP units'). Like a 1031, it defers the gain — but instead of landing you in another individual property, it makes you an owner in a diversified, professionally-managed REIT, typically with the ability to convert your units into REIT shares over time. This offers diversification, potential liquidity, passive ownership, and estate-planning advantages that direct property can't match. This guide explains how a 721 exchange works, OP units versus REIT shares, the tax deferral, and who it suits.
What is a 721 exchange?
A 721 exchange is a transaction in which a property owner contributes their real estate to a REIT's operating partnership in exchange for units in that partnership, deferring the gain under Section 721 of the tax code. Section 721 generally provides that no gain or loss is recognized when property is contributed to a partnership in exchange for an interest in the partnership. So instead of selling your property (and paying tax) or doing a 1031 (into another property), you contribute it to the REIT's partnership and receive partnership units, tax-deferred.
The REIT involved is structured as an 'UPREIT' (umbrella partnership REIT), meaning the REIT owns its real estate through an operating partnership. When you contribute your property to that operating partnership, you become a partner, receiving operating partnership units (OP units) representing your stake. These OP units are typically convertible (after a holding period) into REIT shares or cash, giving you a path to the REIT's liquidity and the broader market.
So a 721 exchange transforms your individual property into an ownership interest in a REIT's portfolio — you go from owning a single property to owning units in a partnership that holds many properties (the REIT's portfolio), tax-deferred. This is fundamentally different from a 1031 (which keeps you in direct, individual property ownership); the 721 moves you into the pooled, professionally-managed REIT structure. What a 721 exchange is — contributing property to a REIT's operating partnership for OP units, tax-deferred under Section 721 — is the foundation for understanding this strategy. It converts direct property ownership into REIT ownership without triggering the tax, opening the diversification, liquidity, and estate-planning benefits of REIT ownership. Understanding this core concept sets up how the conversion works and why investors use it.
How the conversion works
The 721 conversion follows a clear path from property to OP units to (potentially) REIT shares. First, you contribute your property to the REIT's operating partnership. The partnership accepts your property and issues you OP units representing the value of your contributed property. This contribution is tax-deferred under Section 721 — you don't recognize the gain on the property at the time of contribution, just as a 1031 defers the gain on an exchange.
Second, you hold the OP units, which function like an ownership stake in the operating partnership (and thus, indirectly, in the REIT's portfolio). The OP units typically pay distributions comparable to the REIT's dividends, so you receive income from your units. The units represent your share of the partnership that owns the REIT's real estate, giving you economic exposure to the diversified portfolio.
Third, after a holding period (often around a year, depending on the REIT), you can typically convert your OP units into REIT shares (commonly on a one-for-one basis) or, in some structures, redeem them for cash. Converting units to shares (or cash) is generally a taxable event that triggers the deferred gain — so the conversion is when the deferred tax comes due (unless deferred further by the step-up at death). This gives you flexibility: hold the units (continuing the deferral and earning distributions) or convert to shares (gaining the liquidity of REIT stock, but triggering the tax). How the conversion works — contribute property for OP units (tax-deferred), hold the units (earning distributions), then optionally convert to REIT shares or cash (a taxable event) — is the mechanical path of a 721 exchange. This path takes you from individual property to REIT ownership, with the deferral preserved until you convert. Understanding the conversion mechanics clarifies how a 721 exchange transforms your property into flexible REIT ownership over time.
A 721 exchange takes you from property to OP units (tax-deferred) to — optionally — REIT shares, transforming a single property into flexible, diversified REIT ownership while preserving the deferral until you convert.
Why convert property into REIT units
Investors convert property into REIT units for several compelling benefits that direct property ownership can't offer. Diversification is primary — a single property concentrates your risk in one asset, location, and tenant, while REIT units give you a stake in the REIT's entire diversified portfolio (many properties, types, and markets). The 721 exchange transforms a concentrated, single-property holding into diversified exposure, reducing the risk of depending on one property.
Liquidity is another major benefit. Direct real estate is illiquid (selling takes time and is all-or-nothing), but REIT units — convertible into REIT shares — offer a path to liquidity, especially with a publicly-traded REIT (whose shares can be sold on the market). You can convert units to shares over time, selling portions as needed, gaining flexibility that a single illiquid property can't provide. So the 721 exchange offers a route from illiquid property to relatively liquid REIT ownership.
Passive ownership and estate planning round out the benefits. REIT units are passive (the REIT manages the properties; you have no management responsibilities), suiting owners ready to step back from active real estate. And the units offer estate-planning advantages — they can be easier to divide among heirs than a single property, and they receive a step-up in basis at death (potentially erasing the deferred gain for heirs), similar to the 1031 step-up benefit. Why convert property into REIT units — for diversification, liquidity, passive ownership, and estate planning — captures the benefits that make the 721 exchange attractive. It transforms a concentrated, illiquid, management-intensive single property into diversified, more liquid, passive REIT ownership with estate-planning advantages, all tax-deferred. These benefits explain why investors use the 721 exchange to convert their property into REIT units.
OP units and REIT shares
Understanding the relationship between OP units and REIT shares is key to the 721 exchange. OP units (operating partnership units) are your interest in the REIT's operating partnership — the entity that directly owns the REIT's real estate. When you do a 721 exchange, you receive OP units, making you a partner in the operating partnership. The units entitle you to distributions (comparable to the REIT's dividends) and represent your economic stake in the partnership's (and thus the REIT's) portfolio.
REIT shares are the publicly-traded (for public REITs) ownership of the REIT itself, which owns the operating partnership. OP units are typically convertible into REIT shares, usually on a one-for-one basis, after a holding period. So OP units and REIT shares represent economically similar interests (both ultimately reflect ownership in the REIT's portfolio), with the OP units being the partnership-level interest you receive in the 721 exchange and the REIT shares being the corporate-level, traded interest you can convert into.
The key practical difference is the tax treatment of conversion. Holding OP units continues the tax deferral (the gain remains deferred), while converting OP units to REIT shares is generally a taxable event (triggering the deferred gain). So the OP units are the tax-deferred holding, and converting to shares is when the tax is triggered (for liquidity). This is why investors often hold OP units (deferring tax, earning distributions) and convert to shares strategically (when they want liquidity and are prepared for the tax, or never — holding until the step-up at death). OP units and REIT shares — the partnership-level interest you receive (deferred) versus the corporate, traded interest you can convert into (triggering tax) — are the two forms of REIT ownership in a 721 exchange. Understanding their relationship (economically similar, but different tax treatment on conversion) is essential to using the 721 exchange, since the choice of when (or whether) to convert units to shares drives the tax timing. The OP-unit-to-share relationship is at the heart of the 721 exchange's flexibility.
The tax deferral
The 721 exchange's tax deferral works similarly to a 1031 in concept but through a different mechanism. Under Section 721, contributing your property to the operating partnership for OP units is tax-deferred — you don't recognize the gain at contribution. Your basis carries over into the OP units (a carryover basis, like the 1031's), so the deferred gain is embedded in the units, to be recognized later when you dispose of them in a taxable transaction.
The deferral continues as long as you hold the OP units. You can hold them indefinitely, earning distributions, with the gain deferred — similar to holding a 1031 replacement property. The deferred gain is triggered when you convert the units to REIT shares (or cash), or if the partnership disposes of the contributed property in a taxable way (subject to any tax protection — discussed in deeper articles). So the deferral persists until a triggering event, giving you control over the timing (by choosing when to convert).
Critically, the step-up in basis at death applies to OP units — if you hold the units until death, your heirs generally receive a stepped-up basis, which can erase the deferred gain, just as with a 1031 replacement property held until death. So the 721 exchange, like the 1031, can ultimately avoid the deferred gain entirely through the step-up, making it a powerful tax and estate-planning tool. The tax deferral — Section 721 deferring the gain at contribution (carryover basis into OP units), continuing until you convert or otherwise dispose, with the step-up at death potentially erasing the gain — is the 721 exchange's core tax benefit, paralleling the 1031's deferral. Understanding the deferral (and the step-up) shows that the 721 exchange offers tax advantages comparable to the 1031, while moving you into REIT ownership. The deferral, with the eventual step-up, is what makes the 721 exchange tax-efficient like its 1031 cousin.
- A 721 exchange contributes property to a REIT's operating partnership for OP units, tax-deferred under Section 721.
- OP units are convertible into REIT shares (often 1:1) after a holding period — but converting triggers the deferred gain.
- Benefits: diversification, liquidity (via convertible units), passive ownership, and estate planning.
- The deferral continues while you hold OP units, and the step-up at death can erase the deferred gain — like a 1031.
Who a 721 exchange suits
A 721 exchange suits property owners with specific goals and circumstances. It's well-suited to owners who want to exit direct real estate ownership into a diversified, passive, more liquid form — those ready to stop managing individual property and gain the diversification and liquidity of REIT ownership. For an owner tired of management, concentrated in one property, and wanting eventual liquidity, the 721 exchange offers an attractive transition, tax-deferred.
It particularly suits owners focused on estate planning. Because OP units can be more easily divided among heirs than a single property, and receive a step-up at death (potentially erasing the deferred gain), the 721 exchange is valuable for owners planning to pass wealth to multiple heirs. The units' divisibility and step-up make estate transfer cleaner and more tax-efficient than a single illiquid property. So estate-focused owners often find the 721 exchange compelling.
However, the 721 exchange suits owners who are comfortable with its trade-offs — notably that it's generally a one-way move (you typically can't do a 1031 exchange out of OP units, since they're a partnership interest, not real property), and that you give up control (the REIT manages the portfolio). So it suits owners ready to commit to REIT ownership as an endpoint, not those wanting to keep trading properties via 1031. Who a 721 exchange suits — owners wanting to exit into diversified, passive, more liquid REIT ownership, especially for estate planning, who are comfortable with the one-way, passive nature — helps you assess whether it fits your goals. It's an excellent tool for the right owner (seeking diversification, liquidity, passivity, and estate benefits as an endpoint), and understanding who it suits clarifies whether the 721 exchange is right for you. The strategy fits owners ready to transition from direct property into REIT ownership for the long term.
How Baker 1031 helps with 721 exchanges
Baker 1031 Investments helps property owners understand and execute 721 exchanges — assessing whether converting your property into REIT units fits your goals (diversification, liquidity, passivity, estate planning), explaining the OP-unit-to-share mechanics and the tax deferral, and coordinating the transaction with the REIT and your advisors. We help you evaluate whether the 721 exchange's benefits and trade-offs align with your situation.
REIT units and related securities are offered through the broker-dealer, Aurora Securities, Inc. (member FINRA/SIPC), and any recommendation follows a suitability review — 721 exchanges involve securities (OP units and REIT shares), so they're available to suitable investors after a review of your circumstances. We coordinate with your CPA on the tax aspects (the deferral, the basis, the conversion timing, the step-up) and with the REIT on the contribution. Our role is to help you determine whether a 721 exchange is right for you and, if so, execute it effectively — transforming your property into diversified, passive REIT ownership tax-deferred, with the liquidity and estate-planning benefits that suit the right owner. The 721 exchange is a powerful tool, and we help you use it appropriately for your goals.
Frequently Asked Questions
What is a 721 exchange?
A transaction in which a property owner contributes their real estate to a REIT's operating partnership in exchange for partnership units (OP units), deferring the gain under Section 721 of the tax code. Section 721 provides that no gain or loss is recognized on contributing property to a partnership for an interest in it. So instead of selling (and paying tax) or doing a 1031, you contribute your property to the REIT's partnership and receive units, tax-deferred — transforming your property into REIT ownership.
How is a 721 exchange different from a 1031 exchange?
A 1031 exchange trades like-kind real property for other real property (keeping you in direct property ownership, able to exchange again). A 721 exchange contributes property to a REIT's operating partnership for OP units (moving you into REIT ownership, generally a one-way move — you typically can't 1031 out of OP units). Both defer the gain, but under different code sections and into different things: 1031 into real property, 721 into a partnership interest (REIT units). The 721 offers diversification and liquidity the 1031 doesn't.
What are OP units?
Operating partnership units — your interest in the REIT's operating partnership (the entity that directly owns the REIT's real estate). When you do a 721 exchange, you receive OP units representing your contributed property's value, making you a partner. The units pay distributions (comparable to the REIT's dividends) and are typically convertible into REIT shares (often one-for-one) after a holding period. OP units are the tax-deferred holding you receive in a 721 exchange — your stake in the REIT's portfolio.
Can I convert OP units to REIT shares?
Yes, typically after a holding period (often around a year, depending on the REIT), OP units can usually be converted into REIT shares (commonly one-for-one) or, in some structures, redeemed for cash. However, converting units to shares (or cash) is generally a taxable event that triggers the deferred gain. So you can convert for liquidity (REIT shares are tradable for public REITs), but doing so triggers the tax. Many investors hold units (deferring tax, earning distributions) and convert strategically or hold until the step-up at death.
Does a 721 exchange defer taxes like a 1031?
Yes — under Section 721, contributing property for OP units is tax-deferred (no gain recognized at contribution), with your basis carrying over into the units. The deferral continues while you hold the units, and is triggered when you convert to shares/cash or the partnership disposes of the property taxably. And like a 1031, the step-up in basis at death applies to OP units — held until death, they can pass to heirs with the deferred gain erased. So the 721 offers tax deferral and step-up benefits comparable to the 1031.
What are the benefits of converting property to REIT units?
Diversification (a stake in the REIT's entire portfolio instead of one property), liquidity (units convertible to REIT shares, especially liquid for public REITs), passive ownership (the REIT manages everything), and estate planning (units are easier to divide among heirs than one property, and get a step-up at death). The 721 exchange transforms a concentrated, illiquid, management-intensive single property into diversified, more liquid, passive REIT ownership with estate advantages, all tax-deferred. These benefits make it attractive for owners exiting direct real estate.
Is a 721 exchange a one-way move?
Generally yes — once you contribute property for OP units, you typically can't do a 1031 exchange out of them, because OP units are a partnership interest, not like-kind real property (and converting them is taxable). So the 721 exchange is usually an endpoint — a commitment to REIT ownership rather than a step you can reverse via 1031. This is an important consideration: the 721 exchange suits owners ready to commit to REIT ownership long-term, not those wanting to keep trading properties. Understand the one-way nature before doing a 721 exchange.
What is an UPREIT?
An umbrella partnership REIT — a REIT structured so it owns its real estate through an operating partnership (rather than directly). This structure enables 721 exchanges: property owners contribute their property to the operating partnership for OP units, tax-deferred. The 'umbrella' is the operating partnership under the REIT, holding the properties. Most REITs that accept 721 contributions are UPREITs. So the UPREIT structure is what makes the 721 exchange possible — it's the framework for contributing property to a REIT tax-deferred.
Do I get income from OP units?
Yes — OP units typically pay distributions comparable to the REIT's dividends, so you receive regular income from your units, reflecting your share of the REIT's portfolio income. This gives you passive income from the REIT's diversified real estate, similar to (and often matching) the dividends REIT shareholders receive. So after a 721 exchange, you earn distributions on your OP units while the gain remains deferred — passive income from diversified real estate, tax-deferred on the underlying gain. The income is one of the benefits of converting to REIT units.
Who should consider a 721 exchange?
Property owners wanting to exit direct real estate into diversified, passive, more liquid REIT ownership — especially those ready to stop managing property, concentrated in one asset, seeking eventual liquidity, or focused on estate planning (the units divide among heirs and get a step-up). It suits owners comfortable with the one-way, passive nature (committing to REIT ownership as an endpoint). It's not for owners wanting to keep trading properties via 1031. If you want to transition from direct property into REIT ownership long-term, the 721 exchange may fit.
Are OP units and REIT shares securities?
Yes — OP units and REIT shares are securities, so a 721 exchange involves securities and is offered through a broker-dealer to suitable investors after a suitability review. This means the 721 exchange is subject to securities regulation, and a financial professional assesses whether it fits your circumstances. The securities nature is a key distinction from a 1031 into direct property (real estate, not a security). Working with a securities-licensed professional is part of executing a 721 exchange properly.
How do I start a 721 exchange?
Begin by assessing whether the 721 exchange fits your goals (diversification, liquidity, passivity, estate planning) and whether you're comfortable with its one-way, passive nature, with a financial professional and your CPA. If it fits, you identify a suitable UPREIT willing to accept your property (or, commonly, reach a 721 exchange through a DST that's later UPREIT'd), and the contribution is structured. Because it involves securities and significant tax considerations, work with a securities-licensed advisor and your CPA. Start with an assessment of fit, then execute with professional guidance.
Glossary
- 721 Exchange
- Contributing property to a REIT's operating partnership for OP units, tax-deferred under Section 721.
- Section 721
- The tax code section deferring gain on contributing property to a partnership for an interest.
- UPREIT
- An umbrella partnership REIT, owning real estate through an operating partnership.
- Operating Partnership (OP)
- The partnership under a REIT that directly owns the properties.
- OP Units
- Operating partnership units received in a 721 exchange, your stake in the partnership.
- REIT Shares
- The corporate, often traded ownership of the REIT, convertible from OP units.
- Conversion
- Exchanging OP units for REIT shares or cash, generally a taxable event.
- Carryover Basis
- The basis carried from the property into the OP units, embedding the deferred gain.
- Tax Deferral
- Postponing the gain via Section 721, until conversion or disposition.
- Step-Up in Basis
- The reset at death that can erase the deferred gain on OP units.
- Diversification
- Exposure to the REIT's whole portfolio instead of one property.
- Liquidity
- The ability to convert units to tradable REIT shares over time.
- Distributions
- Income paid on OP units, comparable to REIT dividends.
- REIT
- A real estate investment trust owning a portfolio of properties.
- Holding Period
- The time before OP units can typically be converted to shares.
- Passive Ownership
- REIT ownership requiring no management by the unit holder.
Sources & References
- Cornell Legal Information Institute. 26 U.S. Code § 721 — Nonrecognition of gain or loss on contribution
- U.S. Securities and Exchange Commission. Investor.gov — Real Estate Investment Trusts (REITs)
- Nareit. What's a REIT (Real Estate Investment Trust)?
- Cornell Legal Information Institute. 26 U.S. Code § 1031
Disclosures
This article is published by Baker 1031 Investments, LLC for general educational purposes for accredited investors and is not an offer to sell or a solicitation of an offer to buy any security, nor is it tax, legal, accounting, or investment advice or a recommendation. Any securities offering is made solely through a sponsor’s private placement memorandum (PPM) following a suitability determination. Securities offered through Aurora Securities, Inc. (ASI), member FINRA / SIPC; Baker 1031 Investments is independent of ASI.
Oil & gas mineral and royalty interests and DST programs are speculative, illiquid securities sold only to verified accredited investors and involve substantial risk, including possible loss of principal, commodity-price and production-decline risk, lack of control, and the risk that an intended 1031 exchange fails to qualify for tax deferral. Whether a particular interest qualifies as like-kind real property is a fact-specific legal determination that varies by state and by the terms of the instrument. Tax results depend on your individual circumstances. Consult your own CPA and attorney before acting. Past performance does not guarantee future results.
