Behind every UPREIT conversion is a single provision of the tax code: Section 721. Just as Section 1031 enables like-kind exchanges, Section 721 enables tax-deferred contributions of property to a partnership — the mechanism that lets property owners contribute real estate to a REIT's operating partnership for units without triggering tax. Understanding Section 721 is key to understanding the 721 exchange: what it says, how it defers the gain, how it differs from Section 1031, when the deferred gain eventually comes due, and how the step-up at death can erase it. While the mechanics are technical (and warrant professional guidance), the core concept is elegant — contributing property to a partnership for an interest in that partnership isn't treated as a taxable sale, so the gain is deferred. This guide explains the tax code behind UPREIT conversions: what Section 721 says, the deferral mechanism, when the gain is triggered, tax protection, and the step-up.
What Section 721 says
Section 721 of the Internal Revenue Code provides, in essence, that no gain or loss is recognized to a partnership or to any of its partners when property is contributed to the partnership in exchange for an interest in the partnership. In plain terms: if you contribute property to a partnership and receive a partnership interest in return, you don't recognize taxable gain on that contribution. The transaction is treated as a tax-deferred contribution, not a taxable sale.
This provision reflects a general principle in partnership taxation: contributing property to a partnership (and receiving an interest reflecting your contribution) is a change in the form of your investment, not a cashing-out, so it shouldn't trigger immediate tax. You've exchanged direct ownership of property for an interest in a partnership that holds the property — a continuation of your investment in a different form. Section 721 codifies this nonrecognition for partnership contributions.
In the UPREIT context, Section 721 is what allows the property owner to contribute their real estate to the REIT's operating partnership for OP units without recognizing the gain. The operating partnership is the partnership, the OP units are the partnership interest, and the contribution falls under Section 721's nonrecognition. So Section 721 is the specific legal basis for the tax deferral in a 721 exchange. What Section 721 says — that no gain or loss is recognized when property is contributed to a partnership for a partnership interest — is the legal foundation of the 721 exchange. This nonrecognition is what makes contributing property to a REIT's operating partnership tax-deferred. Understanding the provision clarifies the legal basis for the deferral, which is the core of how UPREIT conversions work. Section 721 is the tax code behind the entire strategy.
Section 721 vs. Section 1031
Section 721 and Section 1031 are different code sections that both defer gain, but in different transactions. Section 1031 defers gain on a like-kind exchange — trading real property for other like-kind real property. Section 721 defers gain on a contribution of property to a partnership for a partnership interest. So 1031 is about exchanging real property for real property, while 721 is about contributing property to a partnership for an interest in it.
The practical difference is what you end up holding. After a 1031, you hold real property (another individual property), and you can do another 1031 with it later (staying in direct real estate). After a 721, you hold a partnership interest (OP units in the REIT's operating partnership), which is not real property — so you generally can't do a 1031 with it (you can't 1031 a partnership interest). This is why the 721 is often a one-way move into REIT ownership, while the 1031 keeps you able to keep exchanging real property.
Both sections share the deferral concept (carryover basis, gain recognized later) and the step-up benefit (at death). But they apply to different transactions and leave you holding different things (real property vs. partnership interest). Understanding that 721 and 1031 are distinct provisions — both deferring gain, but 1031 for like-kind real property and 721 for partnership contributions — clarifies their different roles. Section 721 vs. Section 1031 — both deferring gain, but 1031 for exchanging like-kind real property (keeping you in direct property) and 721 for contributing property to a partnership (moving you into REIT units) — is a key distinction. The two provisions serve different strategies: 1031 for staying in direct real estate, 721 for transitioning into REIT ownership. Understanding the difference helps you see how 721 enables the UPREIT conversion that 1031 doesn't. They're complementary tools under different code sections.
Both Section 721 and Section 1031 defer gain — but 1031 trades real property for real property (you can exchange again), while 721 contributes property for a partnership interest (generally a one-way move into REIT units).
The tax-deferral mechanism
The Section 721 deferral works through carryover basis, similar to a 1031. When you contribute property to the operating partnership for OP units, you don't recognize the gain, and your basis in the contributed property carries over to become your basis in the OP units (a carryover or substituted basis). So the deferred gain is embedded in your OP units — the difference between the units' value and your (carried-over) basis represents the gain you haven't yet recognized.
This means the gain isn't forgiven; it's deferred and preserved in the units' basis, to be recognized when you eventually dispose of the units in a taxable transaction. The carryover basis is the mechanism that defers the gain — it keeps the gain embedded in your new holding (the OP units), just as a 1031's carryover basis keeps the gain in the replacement property. The deferral continues as long as you hold the units with their carried-over basis.
The operating partnership, for its part, generally takes a carryover basis in the contributed property (the partnership's basis in the property carries over from your basis), preserving the gain at the partnership level too. The detailed partnership tax mechanics (including how built-in gain is allocated) are technical and handled by tax professionals. But the core mechanism is the carryover basis deferring your gain into the OP units. The tax-deferral mechanism — carryover basis embedding the deferred gain in your OP units (and in the partnership's basis in the property), preserving the gain until a taxable disposition — is how Section 721 defers the tax, paralleling the 1031's carryover-basis mechanism. Understanding this mechanism shows that the 721 deferral, like the 1031, preserves rather than forgives the gain, carrying it into your new holding. The carryover basis is the technical heart of the Section 721 deferral.
When the deferred gain is triggered
The deferred gain from a Section 721 contribution is triggered (recognized and taxed) by certain events, which determine the tax timing. The most common trigger is converting your OP units to REIT shares or cash — when you exchange your units for REIT shares (or redeem them for cash), that's generally a taxable disposition of the units, recognizing the deferred gain. So converting units to shares (often done for liquidity) is the typical event that triggers the tax.
Another trigger is the operating partnership disposing of the contributed property in a taxable transaction — if the partnership sells the property you contributed (in a taxable sale), the built-in gain on that property may be triggered and allocated to you (subject to any tax protection — discussed next). So a sale of your contributed property by the partnership can trigger your deferred gain, even without you converting your units.
Other dispositions of the OP units (selling them, certain transfers) can also trigger the gain. The key point is that the deferral continues until one of these triggering events, giving you some control over the timing (by choosing whether and when to convert your units) but also exposure to triggers outside your control (like the partnership selling the property). When the deferred gain is triggered — by converting OP units to shares/cash, by the partnership disposing of the contributed property, or by other dispositions of the units — determines the tax timing of a 721 exchange. Understanding these triggers (and the tax protection that can address the partnership-sale trigger) is essential to managing the deferral. The triggering events are when the deferred tax comes due, so knowing them helps you plan the timing of recognition, which is a key part of using the 721 exchange effectively.
The built-in gain and tax protection
A nuanced aspect of 721 exchanges is the built-in gain and the tax protection that can address it. When you contribute property with a deferred gain (built-in gain) to the operating partnership, that gain remains associated with your contributed property. If the partnership later sells that property in a taxable transaction, the built-in gain could be triggered and allocated to you — meaning you'd owe tax on the gain even though you didn't choose to sell. This is a risk for contributors: a partnership sale of your property triggering your deferred tax.
To address this, UPREIT contributions often include tax protection agreements. These are agreements by the REIT/partnership to protect the contributor from the triggering of their built-in gain for a period — for example, by agreeing not to sell the contributed property in a taxable way for a number of years, or to compensate the contributor (or maintain certain debt the contributor can use) if a triggering sale occurs. Tax protection agreements give contributors some assurance that their deferred gain won't be triggered unexpectedly by a partnership sale, at least for the protection period.
These agreements are negotiated as part of the contribution and vary in their terms (the protected period, the form of protection). They're an important consideration for contributors, since they affect the security of the deferral. The built-in gain and tax protection — the risk that a partnership sale of your contributed property triggers your deferred gain, and the tax protection agreements that can mitigate this risk for a period — are an important nuance of 721 exchanges. Understanding the built-in gain risk and the tax protection that addresses it helps contributors assess the security of their deferral. The tax protection agreement is a key term to understand and negotiate in a 721 exchange, since it affects whether (and for how long) your deferred gain is protected from being triggered by the partnership's actions. This is a technical area warranting professional guidance.
- Section 721 provides that no gain or loss is recognized when property is contributed to a partnership for a partnership interest — the basis of the 721 exchange.
- Unlike Section 1031 (like-kind real property), Section 721 covers partnership contributions — leaving you with OP units (generally a one-way move).
- The deferral works through carryover basis; the gain is triggered by converting units, the partnership selling the property, or other dispositions.
- Tax protection agreements can shield contributors from having their built-in gain triggered by a partnership sale for a period; the step-up at death can erase the gain.
Estate planning and step-up
One of the most powerful aspects of Section 721 (shared with Section 1031) is the estate-planning benefit of the step-up in basis at death. If you hold your OP units until death, your heirs generally receive a stepped-up basis in the units — the basis is reset to the fair market value at your death, which can erase the deferred gain embedded in the units. So the deferred gain that would have been triggered on a conversion or sale can be eliminated if you hold the units until death.
This makes the 721 exchange a powerful estate-planning tool. You contribute property (deferring the gain), hold the OP units (earning distributions, with the gain deferred), and pass them to your heirs at death — who receive the units with a stepped-up basis, able to convert to shares or receive cash with little or no tax on the prior gain. The combination of lifetime deferral and the step-up at death can permanently avoid the deferred gain, transferring wealth tax-efficiently.
The OP units also offer estate-planning advantages in divisibility — they can be more easily divided among multiple heirs than a single property, simplifying the estate. So the 721 exchange serves estate planning both through the step-up (erasing the gain) and the divisibility (easing the transfer). Estate planning and step-up — holding OP units until death for a stepped-up basis that can erase the deferred gain, plus the units' divisibility among heirs — make the 721 exchange a powerful estate-planning tool, paralleling the 1031's step-up benefit. The combination of lifetime deferral and the step-up at death can permanently avoid the gain, while the units ease the estate transfer. Understanding the estate-planning benefits shows why the 721 exchange is especially attractive for owners focused on transferring wealth to heirs tax-efficiently. The step-up is the capstone of the 721 exchange's tax advantages, just as it is for the 1031.
How Baker 1031 helps with Section 721
Baker 1031 Investments helps property owners understand and apply Section 721 — explaining the deferral mechanism, the triggers, the tax protection agreements, and the estate-planning step-up, and coordinating with your CPA and the REIT to structure a 721 exchange that achieves your goals. Because the tax mechanics are technical, we emphasize working with your CPA and advisors to handle the deferral, basis, triggers, and tax protection correctly.
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), available to suitable investors after a review. We don't provide tax or legal advice (that's your CPA and attorney); we help you understand the Section 721 framework and execute the contribution, coordinating with your tax professionals on the technical aspects (deferral, basis, triggers, tax protection, step-up). Our role is to help you use Section 721 effectively — deferring your gain by contributing property to a REIT's operating partnership, with the deferral and estate-planning benefits the provision offers — handled with the professional guidance its technical nature requires. Section 721 is the powerful tax code behind the 721 exchange, and we help you apply it.
Frequently Asked Questions
What is Section 721?
A provision of the Internal Revenue Code stating that no gain or loss is recognized when property is contributed to a partnership in exchange for an interest in the partnership. In plain terms, contributing property to a partnership for a partnership interest isn't a taxable sale — the gain is deferred. In the UPREIT context, Section 721 lets a property owner contribute real estate to a REIT's operating partnership for OP units without recognizing the gain. It's the legal basis for the tax deferral in a 721 exchange.
How is Section 721 different from Section 1031?
Both defer gain, but Section 1031 covers like-kind exchanges (trading real property for real property, keeping you in direct property, able to exchange again), while Section 721 covers contributions of property to a partnership for an interest (leaving you with OP units, generally a one-way move into REIT ownership). After a 1031 you hold real property; after a 721 you hold a partnership interest (not real property, so you can't 1031 it). They're distinct provisions enabling different strategies — 1031 for direct real estate, 721 for REIT conversion.
How does the Section 721 deferral work?
Through carryover basis — when you contribute property for OP units, you don't recognize the gain, and your basis in the property carries over to become your basis in the units. The deferred gain is embedded in the units (the difference between their value and your carried-over basis), to be recognized when you dispose of the units taxably. The deferral continues while you hold the units. This carryover-basis mechanism parallels the 1031 — it preserves (rather than forgives) the gain, carrying it into your OP units.
When is the deferred gain from a 721 exchange triggered?
By certain events: converting your OP units to REIT shares or cash (a taxable disposition of the units), the operating partnership disposing of your contributed property in a taxable sale (triggering the built-in gain, subject to any tax protection), or other dispositions of the units. So the deferral continues until a triggering event. Converting units to shares (for liquidity) is the most common trigger you control; a partnership sale of your property is a trigger that may be outside your control (which tax protection can address).
What is a tax protection agreement?
An agreement by the REIT/operating partnership to protect a contributor from having their built-in (deferred) gain triggered for a period — for example, by agreeing not to sell the contributed property in a taxable way for a number of years, or to compensate the contributor (or maintain certain debt) if a triggering sale occurs. It addresses the risk that a partnership sale of your contributed property triggers your deferred tax unexpectedly. Tax protection agreements are negotiated in the contribution and give contributors assurance their deferral won't be triggered prematurely, for the protected period.
What is built-in gain in a 721 exchange?
The deferred gain on the property you contribute — the difference between the property's value and your basis at contribution. This built-in gain remains associated with the contributed property and embedded in your OP units. If the partnership later sells the property taxably, the built-in gain could be triggered and allocated to you. The built-in gain is the deferred gain that a triggering event (like a partnership sale or your conversion of units) would recognize. Tax protection agreements can shield you from the partnership-sale trigger of your built-in gain for a period.
Does the step-up in basis apply to OP units?
Yes — if you hold your OP units until death, your heirs generally receive a stepped-up basis (reset to fair market value at death), which can erase the deferred gain embedded in the units. So the gain that would be triggered on a conversion or sale can be eliminated by holding until death, letting heirs convert to shares or receive cash with little or no tax on the prior gain. This step-up, paralleling the 1031's, makes the 721 exchange a powerful estate-planning tool — lifetime deferral plus the step-up can permanently avoid the gain.
Can I do a 1031 exchange out of OP units?
Generally no — OP units are a partnership interest, not like-kind real property, so they don't qualify for a 1031 exchange, and converting them is a taxable event. This is why the 721 exchange is usually a one-way move into REIT ownership: once you hold OP units, you can't 1031 them into direct real estate. You can convert them to REIT shares (taxable) or hold them (deferred, until the step-up at death). The inability to 1031 out is an important consideration before doing a 721 exchange — it's an endpoint, not a reversible step.
Is the Section 721 deferral permanent?
It's a deferral, not permanent forgiveness — the gain is deferred until a triggering event (conversion, partnership sale, or other disposition of the units). However, like the 1031, the deferral can become permanent if you hold the OP units until death, when the step-up in basis can erase the deferred gain for your heirs. So the deferral lasts until you trigger it (or indefinitely if you hold until death). It's not automatically permanent, but the step-up at death can make it effectively so for estate purposes.
Why are the Section 721 mechanics considered technical?
Because partnership taxation (which governs 721 contributions) involves complex rules — carryover and substituted basis, the allocation of built-in gain, the treatment of partnership liabilities, the triggers, and the interaction with tax protection agreements. These require professional expertise to handle correctly. The core concept (deferral on contributing property for a partnership interest) is straightforward, but the detailed mechanics are intricate, which is why 721 exchanges warrant an experienced CPA and tax advisors. The technical nature is a reason to work with professionals on a 721 exchange.
Does the partnership recognize gain on my contribution?
No — Section 721 provides nonrecognition for both the contributing partner and the partnership, so neither recognizes gain on the contribution. The partnership generally takes a carryover basis in the contributed property (your basis carries over to the partnership), preserving the gain at the partnership level. So the contribution is tax-deferred for everyone involved, with the gain preserved in the carryover bases (your OP units and the partnership's property basis). The nonrecognition applies broadly to the contribution transaction under Section 721.
Should I get professional help for a 721 exchange?
Yes — the Section 721 mechanics are technical (carryover basis, built-in gain, triggers, tax protection, the step-up), and the transaction involves securities (OP units), so you should work with an experienced CPA (for the tax), possibly an attorney (for the structuring and tax protection agreement), and a securities-licensed advisor (for the OP units). The complexity and the securities nature make professional guidance essential. Don't approach a 721 exchange without experienced tax and securities professionals — the technical and securities aspects require their expertise.
Glossary
- Section 721
- The code section deferring gain on contributing property to a partnership for an interest.
- Nonrecognition
- Not recognizing gain at the time of a transaction, as Section 721 provides.
- Carryover Basis
- The property's basis carrying into the OP units, embedding the deferred gain.
- Substituted Basis
- Another term for the carried-over basis in the partnership interest.
- Built-In Gain
- The deferred gain on contributed property, associated with it in the partnership.
- Tax Protection Agreement
- An agreement shielding a contributor from triggered gain for a period.
- Triggering Event
- An event (conversion, partnership sale) recognizing the deferred gain.
- OP Units
- The partnership interest received, holding the deferred gain.
- Section 1031
- The like-kind exchange provision, distinct from Section 721.
- Operating Partnership
- The partnership to which property is contributed under Section 721.
- Conversion
- Exchanging OP units for REIT shares/cash, a common trigger.
- Step-Up in Basis
- The death-time reset erasing the deferred gain on OP units.
- Partnership Taxation
- The complex rules governing 721 contributions.
- Partnership Interest
- The OP units — a non-real-property interest, ineligible for 1031.
- One-Way Move
- The 721 exchange's generally irreversible nature (can't 1031 out).
- Liability Allocation
- The technical treatment of partnership debt in a 721 contribution.
Sources & References
- Cornell Legal Information Institute. 26 U.S. Code § 721 — Nonrecognition of gain or loss on contribution
- Cornell Legal Information Institute. 26 U.S. Code § 1031
- Cornell Legal Information Institute. 26 U.S. Code § 704(c) — Built-in gain allocations
- IRS. Publication 541, Partnerships
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.
