The OP units you receive in a 721 exchange come with a powerful tax deferral — but that deferral ends when you convert the units to REIT shares. Conversion is generally a taxable event: it triggers the deferred gain you'd been carrying since you contributed your property, plus any appreciation since then. So while converting gives you liquid REIT shares (and the ability to sell them), it has a tax cost that must be planned for. Understanding the tax consequences — what gain is recognized, how the tax is calculated, the difference between partial and full conversion, your basis in the shares afterward, and the strategies to manage the tax — is essential for anyone holding OP units who's considering converting. With careful planning (especially gradual conversion), you can manage the tax while accessing liquidity. This guide explains the tax consequences of converting OP units to REIT shares.
Conversion is a taxable event
The fundamental point is that converting OP units to REIT shares is generally a taxable event. When you exchange your OP units (a partnership interest) for REIT shares, you're disposing of the units, which triggers the recognition of the deferred gain that was embedded in them. So unlike the original 721 contribution (tax-deferred) or simply holding the units (deferral continuing), the conversion ends the deferral and recognizes the gain.
This is because the deferral from the 721 exchange continues only while you hold the OP units. Disposing of the units — whether by converting them to REIT shares, redeeming them for cash, or otherwise selling them — is the triggering event that ends the deferral and recognizes the gain. Conversion to shares is one such disposition, so it triggers the tax. (Redemption for cash similarly triggers the gain.)
The practical implication is that conversion has a tax cost: you'll owe tax on the recognized gain in the year you convert. This is why conversion should be planned (not done impulsively) — you want to convert in a tax-aware way (gradually, timed well) to manage the tax. Conversion is a taxable event — disposing of your OP units (by converting to REIT shares) triggers the deferred gain, ending the 721 deferral — is the foundational fact about the tax consequences of conversion. Understanding that conversion is taxable (unlike holding) sets up what gain is recognized and how to manage the tax. The conversion is the point at which the deferred tax comes due, so understanding and planning for it is essential. Conversion trades the deferral for liquidity, with the tax as the cost.
What gain is recognized
When you convert OP units, the gain recognized is generally the deferred gain from your original property contribution, plus any appreciation in the units' value since the contribution. Recall that your OP units carry a low (carryover) basis from your contributed property, embedding the original deferred gain. When you convert (dispose of the units), the gain is the difference between the value you receive (the REIT shares' value) and your basis in the units — which includes the original deferred gain plus any appreciation since.
So the recognized gain has two components: the original deferred gain (from when you contributed your property — the appreciation up to the 721 exchange) and the post-contribution appreciation (the units' increase in value while you held them). Both are recognized when you convert, because your low basis (reflecting the original deferred gain) and the higher current value (reflecting the appreciation) together produce the total gain.
This means the tax on conversion can be substantial, especially if you held the units for a long time (accumulating appreciation) or contributed low-basis property (large original deferred gain). The longer you held and the more the units appreciated, the larger the recognized gain on conversion. Understanding what gain is recognized — the original deferred gain plus post-contribution appreciation, calculated as the shares' value minus your (low) basis in the units — clarifies the magnitude of the conversion tax. The recognized gain reflects all the appreciation embedded in your units (from the original property and since), which the conversion triggers. Understanding this helps you anticipate the tax of converting, which can be significant for long-held, low-basis-derived units. The recognized gain is the full embedded gain, triggered by conversion.
Converting triggers the full embedded gain — the original deferred gain from your property contribution, plus any appreciation in the units since — calculated as the shares' value minus your low basis in the units.
Calculating the tax
The tax on the recognized gain is calculated using the applicable tax rates, which can involve the familiar four-layer considerations. The capital gains portion of the gain is taxed at capital gains rates (long-term, up to 20% federal, given the long holding). If the original property had depreciation, the depreciation recapture component may be taxed at recapture rates (up to 25%) — the recapture embedded from the original property carries through and can be recognized on the disposition. The 3.8% net investment income tax may apply, and state income tax applies based on your state.
So the conversion gain can face a tax stack similar to a property sale — capital gains, potential recapture, NIIT, and state tax — on the recognized gain. The exact composition depends on your situation (the original property's depreciation, your income level, your state), which your CPA calculates. The key point is that the recognized gain is taxed at these rates, potentially totaling a substantial percentage of the gain.
Because the tax can be substantial, calculating it (with your CPA) before converting is important — you want to know the tax cost of converting (in total and per unit) to plan how much to convert and when. The CPA models the tax on conversions, so you can convert in a tax-aware way. Calculating the tax — applying the capital gains, recapture, NIIT, and state-tax considerations to the recognized gain, as your CPA computes — shows the tax cost of converting OP units. The conversion gain can face a tax stack like a property sale, so calculating it before converting is essential to planning. Understanding how the tax is calculated helps you anticipate the cost and plan your conversions accordingly. The tax calculation, done with your CPA, is the basis for managing the conversion tax wisely.
Partial vs. full conversion
A key tax-management choice is whether to convert all your units at once (full conversion) or some at a time (partial conversion). Full conversion — converting all your OP units to shares at once — triggers the entire deferred gain in one year, producing the full tax bill at once. This might be appropriate if you need to liquidate everything, but it concentrates the tax into one year (potentially pushing you into higher brackets and triggering the full NIIT and recapture at once).
Partial conversion — converting some units now and others later — triggers only the gain on the converted portion each time, spreading the gain recognition (and tax) over multiple years. This is generally more tax-efficient, because it spreads the tax (avoiding a single large hit), can keep more of the gain in lower brackets each year, and lets the unconverted units continue deferring (and earning distributions). So partial conversion is the common tax-management approach.
The choice between partial and full conversion thus has significant tax implications. Most investors convert partially (gradually), spreading the tax and accessing liquidity incrementally, unless they need full liquidation. Partial conversion also preserves optionality — you can convert more (or stop) based on your needs and tax situation each year. Partial vs. full conversion — full conversion triggering the entire gain at once versus partial conversion spreading the gain (and tax) over years — is a key tax-management choice. Partial (gradual) conversion is generally more tax-efficient, spreading the tax, keeping more gain in lower brackets, and preserving deferral on the unconverted units. Understanding this choice helps you convert in the most tax-efficient way for your needs. Partial conversion is the standard approach for managing the conversion tax, accessing liquidity while spreading the tax over time.
Basis after conversion
After converting OP units to REIT shares, your basis in the shares is important for future tax purposes. When you convert and recognize the gain, your basis in the new REIT shares generally becomes their fair market value at conversion (since you've recognized the gain up to that value) — a 'stepped-up' basis reflecting the recognized gain. So the shares you receive have a basis equal to their value at conversion, not the old low basis of the units.
This matters for when you later sell the shares. Because the shares' basis is their value at conversion, selling them shortly after conversion (at roughly that value) produces little additional gain — you've already recognized the gain on conversion. Further gain (or loss) on the shares would be based on their value change after conversion. So the conversion 'resets' your basis to the shares' value, and subsequent share gains/losses are measured from there.
This means the conversion is the main taxable event; selling the shares afterward (if soon, at a similar price) adds little tax. So if you convert and sell promptly for liquidity, the tax is essentially the conversion gain (the share sale adding little). If you hold the shares after converting, future appreciation/depreciation is measured from the conversion-value basis. Basis after conversion — your REIT shares taking a basis equal to their value at conversion (reflecting the recognized gain), so subsequent share gains/losses are measured from there — is an important consequence to understand. The conversion resets your basis to the shares' value, making the conversion the main taxable event and subsequent prompt sales low-tax. Understanding the post-conversion basis clarifies the tax of selling the shares afterward. The basis reset at conversion means the conversion gain is the primary tax, with subsequent share transactions measured from the new basis.
- Converting OP units to REIT shares is a taxable event that triggers the deferred gain (ending the 721 deferral).
- The recognized gain is the original deferred gain plus appreciation since contribution — taxed at capital gains, recapture, NIIT, and state rates.
- Partial (gradual) conversion spreads the gain and tax over years; full conversion triggers it all at once.
- After conversion, your REIT shares take a basis equal to their conversion value, so subsequent prompt sales add little tax.
Strategies to manage the tax
Several strategies help manage the tax of converting OP units. Gradual conversion is the primary one — converting portions over multiple years spreads the gain recognition, smoothing the tax, keeping more gain in lower brackets, and preserving deferral (and distributions) on the unconverted units. This is the most common and effective strategy for accessing liquidity while managing the tax.
Timing conversions thoughtfully is another strategy — converting in years when your other income is lower (so the gain faces lower brackets), or when you have offsetting deductions or losses (to reduce the net tax), as your CPA advises. Coordinating conversions with your overall tax situation each year optimizes the tax. So you convert not just gradually but in well-chosen years.
The ultimate strategy is to hold units you don't need to convert — keeping them deferred (and income-producing) until the step-up at death erases the gain. By converting only what you need for liquidity (paying tax on that) and holding the rest toward the step-up, you minimize the conversion tax and preserve the deferral/step-up on the rest. So the strategies combine: convert gradually and thoughtfully what you need, and hold the rest for the step-up. Strategies to manage the tax — gradual conversion (spreading the gain), timing conversions in favorable years, and holding the rest toward the step-up at death — let you access liquidity while minimizing and deferring the conversion tax. These strategies, coordinated with your CPA, optimize your after-tax outcome. Understanding the strategies shows that the conversion tax is manageable with planning — you don't have to convert everything (and pay all the tax) at once. Thoughtful conversion management is the key to using OP units' liquidity tax-efficiently.
How Baker 1031 helps with conversion tax
Baker 1031 Investments helps investors understand and manage the tax consequences of converting OP units to REIT shares — explaining that conversion is taxable, what gain is recognized, how the tax is calculated, and the strategies (gradual conversion, timing, holding for the step-up) to manage it. We help you plan your conversions in a tax-aware way, coordinating with your CPA, so you access liquidity while managing the tax.
OP units, REIT shares, 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 calculates the conversion tax and advises on timing); we help you understand the conversion's tax consequences and coordinate a tax-aware conversion strategy with your CPA. Our role is to help you manage the conversion tax wisely — converting gradually and thoughtfully what you need for liquidity, while holding the rest toward the step-up — so you use your OP units' liquidity in the most tax-efficient way. Understanding and planning the conversion tax is part of using the 721 exchange effectively, and we help you do it.
Frequently Asked Questions
Is converting OP units to REIT shares taxable?
Yes, generally — converting OP units to REIT shares is a taxable event that triggers the deferred gain embedded in the units (ending the 721 deferral). When you dispose of the units (by converting to shares), you recognize the gain you'd been deferring since contributing your property, plus any appreciation since. So conversion has a tax cost, unlike simply holding the units (deferral continuing). This is why conversion should be planned in a tax-aware way (gradually, timed well) rather than done impulsively. The conversion is when the deferred tax comes due.
What gain is recognized when I convert?
The original deferred gain from your property contribution (the appreciation up to the 721 exchange, embedded in your units' low basis) plus any post-contribution appreciation (the units' increase in value while you held them). It's calculated as the REIT shares' value minus your basis in the units. So the recognized gain reflects all the appreciation embedded in your units — from the original property and since. The longer you held and the more the units appreciated, the larger the recognized gain on conversion. It can be substantial for long-held, low-basis-derived units.
How is the conversion tax calculated?
The recognized gain is taxed using the applicable rates — capital gains rates (up to 20% federal, long-term), potential depreciation recapture (up to 25%, from the original property's depreciation), the 3.8% NIIT, and state income tax. So the conversion gain can face a tax stack similar to a property sale. The exact composition depends on your situation (the original property's depreciation, your income, your state), which your CPA calculates. Calculating the tax before converting (with your CPA) is essential to planning how much to convert and when.
Should I convert all my units at once or gradually?
Gradually, in most cases — partial (gradual) conversion triggers only the gain on the converted portion each time, spreading the gain and tax over multiple years (smoothing the tax, keeping more gain in lower brackets, and preserving deferral and distributions on the unconverted units). Full conversion triggers the entire gain at once (a large tax bill, potentially in higher brackets). So gradual conversion is generally more tax-efficient. Convert all at once only if you need full liquidation; otherwise, gradual conversion is the standard tax-management approach.
What's my basis in the REIT shares after converting?
Generally their fair market value at conversion — since you've recognized the gain up to that value, the shares take a 'stepped-up' basis equal to their conversion value (not the old low basis of the units). This matters for selling the shares later: because their basis is the conversion value, selling them shortly after (at roughly that value) produces little additional gain. So the conversion resets your basis to the shares' value, making the conversion the main taxable event and subsequent prompt sales low-tax. Future share gains/losses are measured from the conversion-value basis.
Can I avoid the conversion tax?
You can defer it by not converting (holding the units, with the deferral continuing) and ultimately avoid it on units you hold until death (when the step-up erases the gain). But if you convert (to access liquidity), you generally trigger the gain. So you avoid the conversion tax by holding rather than converting — converting only what you need for liquidity (paying tax on that) and holding the rest toward the step-up. There's no way to convert tax-free, but you can minimize the conversion tax by holding most units and converting only as needed, with the step-up eliminating the gain on what you never convert.
How can I manage the conversion tax?
Convert gradually (spreading the gain over years), time conversions in favorable years (lower other income, available deductions/losses, as your CPA advises), and hold units you don't need toward the step-up at death (erasing the gain on those). By converting only what you need for liquidity, gradually and thoughtfully, and holding the rest, you minimize and spread the conversion tax. These strategies, coordinated with your CPA, optimize your after-tax outcome. The conversion tax is manageable with planning — you don't have to convert everything and pay all the tax at once.
Does the original property's depreciation affect the conversion tax?
Yes — if your originally-contributed property had depreciation, the depreciation recapture component embedded from that property can be recognized when you convert (the recapture carries through the 721 exchange into the units, and is triggered on disposition). So the conversion gain may include a recapture portion taxed at recapture rates (up to 25%), in addition to the capital gains portion. This is part of why the conversion tax can be substantial for units derived from depreciated property. Your CPA accounts for the recapture in calculating the conversion tax.
Is converting to shares different from redeeming for cash?
Both are generally taxable dispositions of your OP units that trigger the deferred gain — so both have similar tax consequences (recognizing the gain). The difference is what you receive: converting to shares gives you REIT shares (which you can then hold or sell), while redeeming gives you cash directly. In both cases, you recognize the gain on the disposed units. So whether you convert to shares or redeem for cash, you trigger the tax; the choice affects what you hold afterward (shares vs. cash), not the basic taxability of the disposition.
When should I convert OP units?
When you need liquidity and are prepared for the tax — ideally converting gradually, in tax-favorable years, only as much as you need. Many investors hold their units long-term (for income and deferral) and convert only when they need cash, spreading the conversions to manage the tax. If you don't need liquidity, holding (toward the step-up) avoids the conversion tax entirely. So convert when you need liquidity, doing so gradually and thoughtfully; hold otherwise. Time your conversions with your CPA's guidance to manage the tax. There's no requirement to convert — you convert when liquidity needs arise.
Does conversion trigger state tax too?
Generally yes — state income tax applies to the recognized gain based on your state (and potentially the state where the original property was located, depending on state rules and any clawback provisions). So the conversion gain faces state tax in addition to federal capital gains, recapture, and NIIT. The state-tax treatment depends on your state and the specifics, which your CPA addresses. For investors in high-tax states, the state tax adds significantly to the conversion tax, reinforcing the value of gradual, well-timed conversion. Your CPA handles the state-tax aspects of conversion.
Does Baker 1031 calculate my conversion tax?
No — your CPA calculates the conversion tax and advises on timing, as tax advice is their role. We help you understand the conversion's tax consequences (that it's taxable, what gain is recognized, the strategies) and coordinate a tax-aware conversion strategy with your CPA. So we help you plan and manage the conversion in a tax-aware way, while your CPA does the actual tax calculation and advice. The conversion tax planning is a coordination between us (the strategy and execution) and your CPA (the tax calculation and advice), ensuring you convert tax-efficiently.
Glossary
- Conversion
- Exchanging OP units for REIT shares, a taxable event.
- Taxable Event
- A disposition (like conversion) that triggers the deferred gain.
- Recognized Gain
- The gain triggered on conversion — deferred gain plus appreciation.
- Deferred Gain
- The original embedded gain, recognized when you convert.
- Carryover Basis
- The low basis in the units, producing the gain on conversion.
- Depreciation Recapture
- A gain component (up to 25%) from the original property, recognized on conversion.
- Net Investment Income Tax
- The 3.8% tax that may apply to the conversion gain.
- Capital Gains Rate
- The rate (up to 20%) on the capital-gain portion of the conversion.
- Partial Conversion
- Converting some units, spreading the gain over years.
- Full Conversion
- Converting all units at once, triggering the entire gain.
- Gradual Conversion
- Converting portions over time to manage the tax.
- Basis After Conversion
- The shares' basis (their conversion value) for future sales.
- Redemption
- Exchanging units for cash, also triggering the gain.
- Step-Up in Basis
- The death-time reset avoiding tax on units you never convert.
- Tax Timing
- Choosing favorable years to convert and recognize gain.
- Four-Layer Tax Stack
- Capital gains, recapture, NIIT, and state tax on the conversion gain.
Sources & References
- Cornell Legal Information Institute. 26 U.S. Code § 721 — Nonrecognition of gain or loss on contribution
- IRS. Topic No. 409, Capital Gains and Losses
- IRS. Publication 541, Partnerships
- Cornell Legal Information Institute. 26 U.S. Code § 1014 — Basis of property acquired from a decedent
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.
