After a 721 exchange, the income you receive on your OP units is taxed differently from how you might expect — because OP units are partnership interests, their distributions are taxed under partnership tax rules, not the simpler rules for REIT dividends. This means you report your share of the operating partnership's income (reported to you on a Schedule K-1), the distributions may include components like ordinary income and return of capital with different tax treatment, and the partnership's depreciation passes through to potentially shelter some of your income. Understanding how OP unit distributions are taxed helps you anticipate your tax situation and coordinate with your CPA. This guide explains OP units and partnership taxation, the Schedule K-1, the distribution components, return of capital and basis, the depreciation pass-through, and a comparison to REIT dividends. (This is educational; consult your CPA for your specific tax situation.)
OP units and partnership taxation
The key to understanding OP unit distribution taxation is that OP units are partnership interests, so they're taxed under partnership tax rules. The operating partnership is a partnership (a pass-through entity for tax purposes), and you (as an OP unit holder) are a partner. Partnership taxation differs from corporate (REIT) taxation: instead of being taxed on the distributions you receive (like dividends), you're generally taxed on your distributive share of the partnership's income (whether or not distributed).
This is the pass-through nature of partnership taxation: the partnership's income (and deductions, like depreciation) passes through to the partners, who report their share on their own returns. So as an OP unit holder, you report your share of the operating partnership's net income (after its deductions, including depreciation), which may differ from the cash distributions you receive.
The distributions themselves are generally treated under partnership distribution rules (often reducing your basis rather than being immediately taxable, discussed below), separate from the taxation of your share of income. So partnership taxation involves taxing your share of the partnership's income (pass-through) and handling the distributions under partnership distribution rules. OP units and partnership taxation — OP units being partnership interests taxed under partnership rules (you're taxed on your distributive share of the partnership's income, with the distributions handled under partnership distribution rules), reflecting the pass-through nature — is the foundation for understanding OP unit distribution taxation. Partnership taxation differs from REIT dividend taxation. Understanding the partnership-taxation framework sets up the details (the K-1, the components, the basis). OP unit distributions are taxed under partnership rules, which is the key distinction from REIT dividends.
The Schedule K-1
A practical hallmark of OP unit taxation is that you receive a Schedule K-1, not a 1099. Because the operating partnership is a partnership, it reports each partner's share of the partnership's income, deductions, and other items on a Schedule K-1 (the partnership tax form), which it provides to you. So instead of a 1099-DIV (which a REIT would provide for dividends), you get a K-1 reflecting your share of the partnership's tax items.
The K-1 reports your distributive share of the partnership's income (ordinary income, capital gains, etc.), deductions (including depreciation), and other items — which you use to report your OP unit income on your tax return. So the K-1 is the key document for your OP unit taxation, showing what you must report. Your CPA uses the K-1 to prepare your return.
Receiving a K-1 has practical implications — K-1s are sometimes issued later than 1099s (potentially affecting when you can file), and they're more complex (requiring a CPA to interpret). So OP unit holders should be prepared for K-1 reporting (vs. the simpler 1099 of REIT shares). The Schedule K-1 — the partnership tax form reporting your distributive share of the operating partnership's income, deductions, and other items (instead of a 1099), which you use to report your OP unit income — is the key tax document for OP unit holders. The K-1 reflects partnership taxation. Understanding the K-1 clarifies how your OP unit income is reported. OP unit holders receive a K-1 (not a 1099), reflecting the partnership taxation, which your CPA uses to prepare your return.
OP unit holders receive a Schedule K-1 (not a 1099) — the partnership tax form reporting your share of the operating partnership's income, deductions, and depreciation, which your CPA uses for your return.
Components of the distribution
OP unit income (via the K-1) can include various components with different tax treatment. Ordinary income — your share of the partnership's net operating income (rental income less expenses and depreciation) — is generally taxed at ordinary rates. This is often the main component of your taxable share, though depreciation reduces it (discussed below).
Other components may include capital gains (if the partnership sells property at a gain, your share is capital gain), interest income, and other items, each taxed per its character. So your K-1 may show multiple income components, each taxed according to its type (ordinary, capital gain, etc.). The cash distributions you receive, meanwhile, are handled under the partnership distribution rules (often reducing basis, discussed next), separate from the income components.
So your OP unit taxation involves reporting your share of the partnership's income components (per the K-1) and handling the cash distributions under the distribution rules. The components and their treatment are detailed on the K-1 and handled by your CPA. Components of the distribution — the various income components (ordinary income from operations, capital gains, etc.) reported on the K-1, each taxed per its character, separate from the cash distributions (handled under distribution rules) — show that OP unit income has multiple components with different treatment. The components reflect the partnership's activities. Understanding the components clarifies the makeup of your OP unit taxable income. Your OP unit income comprises various components (ordinary income, capital gains, etc.) taxed per their character, detailed on the K-1.
Return of capital and basis
An important aspect of OP unit distribution taxation is how the cash distributions interact with your basis, often as a return of capital. Under partnership rules, the cash distributions you receive are generally not immediately taxable to the extent they don't exceed your basis in the OP units — instead, they reduce your basis (treated as a return of capital). So a distribution often isn't taxed when received; it reduces your basis in the units.
This means the cash distributions can be tax-deferred (or tax-advantaged) to the extent of your basis — you receive cash without immediate tax, but your basis decreases. Only if distributions exceed your basis (reducing it to zero) would the excess generally be taxable (as gain). So the return-of-capital treatment can make some of your cash distributions tax-efficient (received without immediate tax, reducing basis).
This interacts with the income you report (your share of the partnership's income, which can increase your basis, while distributions decrease it). So your basis changes over time (up for income allocated, down for distributions), and the return-of-capital nature of distributions affects their immediate taxability. Your CPA tracks your basis and the distribution treatment. Return of capital and basis — the cash distributions generally reducing your basis (treated as return of capital) rather than being immediately taxable to the extent of basis, making some distributions tax-efficient, with your basis adjusting for income and distributions — is an important aspect of OP unit taxation. The return-of-capital treatment can make distributions tax-advantaged. Understanding return of capital and basis clarifies how cash distributions are taxed (often deferred via basis reduction). The cash distributions often reduce basis (return of capital) rather than being immediately taxed, a tax-efficient feature your CPA tracks.
Depreciation pass-through
A valuable feature of OP unit taxation is the depreciation pass-through, which can shelter some of your income. Because the operating partnership owns real estate, it depreciates the properties, and this depreciation passes through to the partners (including you) via the K-1. So your share of the partnership's income is reduced by your share of the depreciation — sheltering some of the income from tax.
This means your taxable income from the OP units (your share of the partnership's net income) can be lower than the cash you receive, because the depreciation reduces the taxable income. So the depreciation pass-through provides tax efficiency — some of your cash income is sheltered by depreciation, similar to how depreciation shelters direct rental income. This is a benefit of the partnership (pass-through) structure of OP units.
So the depreciation pass-through can make your OP unit income tax-efficient, reducing your taxable income below the cash received. The amount depends on the partnership's depreciation, reflected on your K-1. Depreciation pass-through — the operating partnership's depreciation passing through to you (via the K-1), reducing your taxable income below the cash received, sheltering some income — is a valuable tax-efficiency feature of OP units. The depreciation pass-through reflects the partnership structure. Understanding the depreciation pass-through clarifies why your OP unit taxable income may be lower than your cash distributions. The depreciation pass-through shelters some of your OP unit income, a tax-efficiency benefit of the partnership structure, reflected on your K-1.
- OP units are partnership interests, so their income is taxed under partnership rules — you report your share of the partnership's income (not just distributions).
- You receive a Schedule K-1 (not a 1099), reporting your share of the partnership's income, deductions (including depreciation), and other items.
- Cash distributions often reduce your basis (return of capital) rather than being immediately taxed — a tax-efficient feature.
- The partnership's depreciation passes through to shelter some of your income; your CPA handles the K-1 and the calculations.
Comparing to REIT dividend taxation
Comparing OP unit taxation to REIT dividend taxation highlights the differences. REIT shares (if you convert to them) pay dividends, taxed under corporate/dividend rules and reported on a 1099-DIV. REIT dividends are generally taxed as ordinary income (REIT dividends typically don't qualify for the lower qualified-dividend rates, though a portion may be eligible for the qualified business income deduction), with some dividends possibly being capital gains or return of capital. So REIT dividends have their own (corporate-based) tax treatment, reported on a 1099.
OP unit distributions, by contrast, are taxed under partnership rules (your share of partnership income, K-1, return of capital reducing basis, depreciation pass-through). So the two differ: REIT dividends (1099, dividend/corporate treatment) versus OP unit distributions (K-1, partnership treatment). The partnership treatment of OP units can offer tax efficiencies (the depreciation pass-through, the return-of-capital basis treatment) that differ from REIT dividend treatment.
So before converting OP units to REIT shares (which changes your taxation from partnership to dividend treatment), understand that the tax treatment shifts. While you hold OP units, you have partnership taxation (K-1); after converting to shares, you'd have dividend taxation (1099). Comparing to REIT dividend taxation — REIT dividends (1099, corporate/dividend treatment, generally ordinary income) versus OP unit distributions (K-1, partnership treatment, with depreciation pass-through and return-of-capital efficiencies) — highlights that OP units and REIT shares are taxed differently. Converting changes the treatment. Understanding the comparison clarifies the tax difference between holding OP units and REIT shares. OP unit distributions (partnership taxation) differ from REIT dividends (corporate taxation), with converting to shares changing the treatment, which your CPA navigates.
How Baker 1031 helps with distribution taxation
Baker 1031 Investments helps OP unit holders understand how their distributions are taxed — explaining the partnership taxation, the Schedule K-1, the distribution components, the return-of-capital basis treatment, the depreciation pass-through, and the comparison to REIT dividends — so you understand your tax situation and can coordinate with your CPA. We help you anticipate the K-1 reporting and the tax efficiencies of OP unit distributions.
REIT units and related securities are offered through the broker-dealer, Aurora Securities, Inc. (member FINRA/SIPC), and any recommendation follows a suitability review. We don't provide tax advice (your CPA handles your specific tax situation, the K-1, and the calculations); we help you understand the framework of OP unit distribution taxation so you can coordinate with your CPA. Our role is to help you understand how OP unit distributions are taxed — the partnership taxation, the K-1, and the tax efficiencies (depreciation pass-through, return of capital) — so you know what to expect and can work with your CPA effectively. Understanding the distribution taxation is part of understanding OP unit ownership, and we help you grasp the framework, with your CPA handling the specifics.
Frequently Asked Questions
How are OP unit distributions taxed?
Under partnership tax rules, because OP units are partnership interests. You're generally taxed on your distributive share of the operating partnership's income (reported on a Schedule K-1), not just the distributions you receive. The cash distributions themselves often reduce your basis (return of capital) rather than being immediately taxable. The partnership's depreciation passes through to shelter some of your income. So OP unit taxation is partnership taxation — different from REIT dividends — and your CPA handles the K-1 and the calculations for your specific situation.
Do I get a 1099 or a K-1 for OP units?
A Schedule K-1, not a 1099. Because the operating partnership is a partnership, it reports your share of its income, deductions (including depreciation), and other items on a K-1 (the partnership tax form), which it provides to you. So instead of a 1099-DIV (which a REIT would provide for dividends), you get a K-1. The K-1 is the key document for your OP unit taxation, which your CPA uses to prepare your return. K-1s can be issued later than 1099s and are more complex, so be prepared for K-1 reporting as an OP unit holder.
What is reported on the K-1?
Your distributive share of the operating partnership's income (ordinary income from operations, capital gains if the partnership sells property, interest, etc.), deductions (including your share of depreciation), and other tax items. You use the K-1 to report your OP unit income on your tax return. The K-1 reflects the partnership's activities passed through to you. So the K-1 shows what you must report from your OP units — the various income components and deductions — which your CPA interprets and uses to prepare your return. It's more detailed than a simple dividend 1099.
Are my OP unit cash distributions taxable when I receive them?
Often not immediately — under partnership rules, cash distributions are generally not immediately taxable to the extent they don't exceed your basis in the units; instead, they reduce your basis (treated as a return of capital). So a distribution often isn't taxed when received; it reduces your basis. Only if distributions exceed your basis (reducing it to zero) would the excess generally be taxable (as gain). So the cash distributions can be tax-efficient (received without immediate tax, reducing basis). Note you're separately taxed on your share of the partnership's income (via the K-1).
What is return of capital for OP units?
The treatment of cash distributions as reducing your basis (rather than being immediately taxable) to the extent of your basis. Under partnership rules, distributions are generally a return of capital up to your basis — you receive the cash without immediate tax, but your basis decreases. This makes some of your cash distributions tax-efficient (deferred via basis reduction). Only distributions exceeding your basis would generally be taxable. So return of capital is a tax-advantaged feature of OP unit distributions, where cash is received without immediate tax, reducing basis. Your CPA tracks your basis and the return-of-capital treatment.
How does depreciation affect my OP unit income?
The operating partnership depreciates its real estate, and this depreciation passes through to you (via the K-1), reducing your share of the partnership's income — sheltering some of your income from tax. So your taxable income from the OP units can be lower than the cash you receive, because the depreciation reduces the taxable income. This depreciation pass-through provides tax efficiency, similar to how depreciation shelters direct rental income. It's a benefit of the partnership (pass-through) structure of OP units, making your OP unit income tax-efficient. The amount depends on the partnership's depreciation, shown on your K-1.
Why is my taxable OP unit income different from my cash distributions?
Because of partnership taxation: you're taxed on your share of the partnership's income (reduced by depreciation), while your cash distributions are handled separately (often reducing basis as return of capital). So your taxable income (your share of net income, after depreciation) can differ from the cash you receive (which may be partly return of capital). The depreciation pass-through can make your taxable income lower than your cash, while the return-of-capital treatment can make some cash non-taxable when received. So the two amounts differ due to partnership tax mechanics, which your CPA reconciles via the K-1.
How does OP unit taxation compare to REIT dividends?
They differ. REIT shares pay dividends taxed under corporate/dividend rules (reported on a 1099-DIV, generally taxed as ordinary income, though a portion may qualify for the QBI deduction). OP unit distributions are taxed under partnership rules (reported on a K-1, with your share of partnership income, return-of-capital basis treatment, and depreciation pass-through). So OP units (partnership taxation, K-1) differ from REIT shares (dividend taxation, 1099). The partnership treatment of OP units can offer efficiencies (depreciation pass-through, return of capital). Converting OP units to shares changes the treatment from partnership to dividend.
Does converting OP units to shares change my taxation?
Yes — while you hold OP units, you have partnership taxation (K-1, your share of partnership income, etc.). After converting to REIT shares, you'd have dividend taxation (1099-DIV, REIT dividends). So converting changes your ongoing income taxation from partnership to dividend treatment (in addition to triggering the deferred gain on the conversion itself). So the conversion shifts your tax treatment. While holding units, expect partnership (K-1) taxation; after converting, expect dividend (1099) taxation. Your CPA handles both. Understand this shift when considering conversion, as it changes your ongoing income tax reporting.
Is OP unit income tax-efficient?
It can be — the partnership structure offers tax efficiencies: the depreciation pass-through shelters some of your income (reducing taxable income below the cash received), and the return-of-capital treatment can make some cash distributions non-taxable when received (reducing basis). So OP unit income often carries tax efficiency from the underlying real estate's depreciation, similar to direct rental income. This is a benefit of the partnership (pass-through) structure. However, the specifics depend on the partnership's activities and your situation, which your CPA assesses. So OP unit income can be tax-efficient, reflecting the real estate's depreciation.
Should I get help with OP unit taxation?
Yes — OP unit taxation (partnership taxation, the K-1, the components, basis tracking, depreciation pass-through) is complex, so you should work with a CPA experienced in partnership taxation. The K-1 requires interpretation, your basis must be tracked (for the return-of-capital treatment), and the various components must be reported correctly. So a CPA is essential for OP unit taxation. We help you understand the framework (partnership taxation, the K-1, the efficiencies), but your CPA handles your specific tax situation and the calculations. Don't navigate OP unit taxation without a CPA — the partnership rules are complex and warrant professional handling.
Will OP units complicate my tax return?
Somewhat — receiving a K-1 (instead of a simple 1099) adds complexity to your return, since the K-1's various items (income components, deductions, basis adjustments) must be entered and reconciled. K-1s also sometimes arrive later than 1099s, which can affect your filing timing (you may need to wait for the K-1, or file an extension). So OP units do add some tax-return complexity compared to simpler investments. However, an experienced CPA handles K-1 reporting routinely, so it's manageable with professional help. The added complexity is a practical consideration of OP unit ownership, addressed by working with a CPA experienced in partnership K-1s.
Could I owe tax on income I didn't receive in cash?
Potentially — because partnership taxation taxes your distributive share of the partnership's income (whether or not distributed), you could in some cases owe tax on allocated income exceeding your cash distributions (though the depreciation pass-through often reduces the taxable income below the cash). This is a feature of partnership taxation (you're taxed on your share of income, not just cash received). In practice, for real estate partnerships, depreciation often keeps the taxable income at or below the cash distributions, but it depends on the specifics. Your CPA assesses whether your allocated income exceeds your cash, so you understand your tax liability. This is a partnership-taxation nuance to be aware of.
Is the depreciation pass-through similar to owning property directly?
Yes, conceptually — just as direct property ownership lets you deduct depreciation against your rental income (sheltering it), OP unit ownership passes through the partnership's depreciation to shelter your share of the income. So you retain a depreciation benefit similar to direct ownership, through the partnership structure, even though you no longer own property directly. This is one reason OP unit income can be tax-efficient like direct rental income. The mechanism differs (pass-through via the K-1 rather than your own depreciation schedule), but the benefit — depreciation sheltering some income — is comparable. Your CPA handles the pass-through depreciation on your K-1.
Glossary
- Partnership Taxation
- The pass-through tax rules governing OP unit income.
- Schedule K-1
- The partnership tax form reporting your share of income and deductions.
- Distributive Share
- Your share of the partnership's income, taxed to you.
- Pass-Through
- The partnership's income and deductions flowing to the partners.
- Return of Capital
- Distributions reducing basis rather than being immediately taxed.
- Basis
- Your investment basis in the OP units, adjusted for income and distributions.
- Depreciation Pass-Through
- The partnership's depreciation sheltering your income.
- Ordinary Income
- A common component of OP unit income, taxed at ordinary rates.
- Capital Gains
- A component if the partnership sells property at a gain.
- 1099-DIV
- The form for REIT dividends, contrasted with the K-1.
- REIT Dividends
- Corporate-taxed income from REIT shares, after conversion.
- Qualified Business Income Deduction
- A possible deduction for some REIT dividends.
- Cash Distribution
- The cash paid on OP units, often a return of capital.
- Net Operating Income
- The partnership's income (less expenses, depreciation) shared to you.
- Tax Efficiency
- The shelter from depreciation and return-of-capital treatment.
- Conversion
- Exchanging units for shares, changing the tax treatment.
Sources & References
- IRS. Publication 541, Partnerships
- IRS. About Schedule K-1 (Form 1065)
- Cornell Legal Information Institute. 26 U.S. Code § 731 — Partnership distributions
- Cornell Legal Information Institute. 26 U.S. Code § 721 — Nonrecognition of gain or loss on contribution
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.
