OP Units Explained: How Operating Partnership Units Work

When investors learn about the 721 exchange, the part that stays fuzzy is what they end up holding: operating-partnership units, or "OP units." They are neither real estate nor quite REIT stock, and that in-between nature is exactly what makes the UPREIT work — and what trips people up. This memo demystifies OP units: where they come from, how they pay you, how and when you can turn them into cash or shares, and how they're taxed along the way.

What OP units are

A REIT structured as an "UPREIT" doesn't own its properties directly; it owns them through an operating partnership, of which the REIT is the general partner. OP units are limited-partnership interests in that operating partnership. When you complete a 721 exchange, you contribute your property (or DST interest) to the operating partnership and receive OP units in return.

The defining feature of OP units is that they are designed to be economically equivalent to the REIT's common shares. A unit and a share generally carry the same value and the same distribution per period; the difference is legal form (a partnership interest versus a share of stock) and the tax consequences that flow from it. Think of an OP unit as a share of the REIT in a partnership wrapper — a wrapper that exists precisely to allow your contribution to be tax-deferred.

How you receive them

You receive OP units by contributing appreciated property to the operating partnership under Section 721, which generally makes the contribution tax-free. The number of units you get is set by a conversion ratio — typically your property's agreed value divided by the value of one unit (which tracks one REIT share). If your contributed interest is worth, say, the equivalent of 10,000 units at the current unit value, that's what you receive.

From that moment, your economic exposure shifts from a single property to the whole REIT portfolio behind the operating partnership. You've traded a concentrated, directly held asset for a diversified, indirect one — the core trade of the UPREIT, examined in our downsides memo.

How distributions work

OP units pay distributions that mirror the REIT's dividend, generally on the same schedule and per-unit amount as a REIT share. This is the income you live on while holding the units, and for many 721 investors it's the whole point — passive cash flow from a diversified portfolio without managing anything.

Because you're a limited partner rather than a shareholder, these distributions come to you through the partnership and are reported on a Schedule K-1 rather than the 1099-DIV a REIT shareholder receives. The economics are designed to match a shareholder's, but the tax reporting runs through partnership rules, which is one reason OP unitholders should keep a tax advisor in the loop.

Converting OP units to REIT shares

OP units aren't permanent. After an initial holding period — often around a year, set by the partnership agreement — you generally gain the right to tender your units, at which point the REIT typically elects to deliver REIT shares (commonly one-for-one) or, at its option, cash. Converting to shares is what gives a 721 investor a path to the liquidity of the REIT's stock, especially when the REIT is publicly traded.

The crucial caveat: conversion is a taxable event. Tendering your OP units recognizes the deferred capital gain (and depreciation recapture) on the portion converted. The deferral you preserved by taking units in the first place ends when you turn them into shares. That's why many investors convert gradually, spreading the tax over several years, rather than all at once.

Redeeming for cash

Instead of (or in addition to) converting to shares, units can often be redeemed for cash. For a publicly traded REIT this is straightforward; for a non-traded REIT, redemption runs through a program with caps, possible queues, and the sponsor's discretion to limit or suspend redemptions in stressed conditions. Either way, like conversion, redeeming for cash is a taxable disposition that triggers the deferred gain. The practical lesson is that there's no tax-free way to get your money out of OP units short of holding them until death — which is exactly why estate planning figures so heavily in 721 strategy.

Voting and other rights

OP unitholders are limited partners, not shareholders, so they generally do not have the voting rights REIT shareholders enjoy on matters like electing the board. The REIT, as general partner, controls the operating partnership. Partnership agreements often grant unitholders certain protective rights — for example, limits on actions that would unfairly trigger their built-in gain — but you should not expect a meaningful voice in governance. In practical terms, taking OP units means accepting passive, non-voting participation in the REIT's fortunes; if governance influence matters to you, this is part of what you give up.

How OP units are valued

Because OP units track REIT shares, their value moves with the share value. For a publicly traded REIT, that's a live, transparent market price. For a non-traded REIT, value is set by periodic net asset value (NAV) appraisals rather than a market, which means the stated value can lag real conditions and that redemptions are typically based on that appraised figure. Understanding which kind of REIT issued your units tells you how reliable — and how current — your unit value really is, and how genuine the "liquidity" you've been promised will be.

Tax treatment over the holding period

While you hold OP units, your deferred gain stays deferred; it isn't recognized simply by holding. You report your share of partnership income on a K-1, and cash distributions are generally not taxable to the extent of your basis in the units (though they reduce that basis). The deferred built-in gain is recognized later — on conversion or redemption, as described, or potentially if the operating partnership sells the contributed property in a way that passes the gain through to you.

And the most favorable outcome of all comes from not selling: hold the units until death, and your heirs may receive a stepped-up basis that can eliminate the deferred gain entirely. That estate dimension is significant enough to warrant its own treatment, which we give in estate planning with a 721 exchange.

Frequently Asked Questions

Glossary

Operating Partnership

The partnership through which an UPREIT owns its properties; the REIT is the general partner.

OP Units

Limited-partnership units in the operating partnership, economically equivalent to REIT shares.

Conversion Ratio

The formula setting how many OP units you receive for contributed property, and how units convert to shares.

Net Asset Value (NAV)

The appraisal-based per-unit value used by non-traded REITs in place of a market price.

Schedule K-1

The tax form reporting a partner's share of partnership income, issued to OP unitholders.

Disclosures