How a 721 Tax Deferred Exchange Works

A Section 721 exchange provides a strategic avenue for property owners to change the form of their investment without an immediate tax liability. Governed by Section 721 of the Internal Revenue Code, this transaction involves contributing property to a partnership in return for an ownership interest. The purpose of this provision is to facilitate the formation of partnerships by allowing individuals to pool resources and business assets.

This mechanism is a form of tax deferral, not tax elimination. The underlying gain on the contributed property does not vanish; instead, it is preserved and may be taxed in the future. This enables property owners to transition from direct ownership of an asset to a stake in a larger enterprise without the friction of an immediate tax bill.

Core Mechanics of a 721 Exchange

The transaction involves a partner contributing property in return for an interest in the partnership, a process that is foundational to the creation of many business partnerships. The term “property” is interpreted broadly and includes a wide array of assets. Tangible assets like real estate, machinery, and vehicles, as well as intangible assets such as patents, copyrights, and even cash, can all be contributed under this provision.

A distinction exists between contributing property and contributing services. When a person receives a partnership interest in exchange for services rendered to the partnership, the transaction falls outside the nonrecognition protection of Section 721. The fair market value of the partnership interest received is considered taxable income to the service provider at the time of receipt. The focus remains squarely on the contribution of capital assets to a joint enterprise.

The partnership interest received by the contributor represents their equity stake in the new entity. This interest gives them rights to a share of the partnership’s future profits and losses, and a claim on its assets upon liquidation. The nature of this interest can vary, from a general partnership interest with unlimited liability and management rights to a limited partnership interest with limited liability and passive involvement. The specifics are determined by the partnership agreement, which outlines the rights and obligations of all partners.

Requirements for Tax Deferral

For a transaction to receive tax-deferred status, it must meet specific criteria. One exception that can disqualify it is the “investment company” rule. If a contribution is made to a partnership that would be classified as an investment company, the tax deferral is not permitted. This rule is designed to prevent investors from using a partnership to diversify a concentrated portfolio of marketable securities without recognizing gain.

A partnership is considered an investment company if, after the exchange, more than 80% of its assets (excluding cash and non-convertible debt) are held for investment and consist of readily marketable stocks or securities. This includes interests in regulated investment companies or real estate investment trusts. If a contribution results in diversification and the partnership meets this 80% test, the contributor must recognize any built-in gain on the property they transferred.

Another area involves the contribution of property subject to liabilities, such as a building with a mortgage. When the partnership assumes the contributor’s debt, the reduction in a partner’s individual liabilities is treated as a distribution of cash to that partner.

If the amount of the liability assumed by the partnership exceeds the tax basis the contributor had in the property, the excess amount is treated as a taxable gain. For instance, imagine an investor contributes a property with a fair market value of $1 million, a tax basis of $300,000, and a mortgage of $400,000. The $100,000 excess is considered a taxable gain to the contributing partner at the time of the exchange.

Tax Implications and Basis Calculation

If the contributing partner receives cash or other property from the partnership, the transaction is analyzed under partnership tax rules. If the contribution and a related distribution are determined to be a “disguised sale,” the partner must recognize a taxable gain. If it is not a disguised sale, the cash is treated as a partnership distribution, which is tax-free unless the amount of cash exceeds the partner’s basis in their partnership interest.

A contributor’s basis in their new partnership interest, often called the “outside basis,” is calculated to preserve the deferred gain. The starting point is the basis of the property the partner contributed. This amount is decreased by any cash received or liabilities assumed by the partnership and increased by any gain the partner recognized on the transaction. This substituted basis determines the gain or loss the partner will recognize when they eventually sell their partnership interest.

Simultaneously, the partnership must determine its basis in the property it received, known as the “inside basis.” The partnership takes the same basis in the property that the contributing partner had at the time of the exchange, which is a “carryover basis.” This basis is then increased by the amount of any gain the contributor recognized on the transfer. This carryover basis mechanism ensures that the deferred gain remains attached to the asset within the partnership.

The UPREIT Transaction Structure

A practical application of the Section 721 exchange is the Umbrella Partnership Real Estate Investment Trust, or UPREIT. This structure is used by publicly traded REITs to acquire properties from individual owners in a tax-efficient manner. It allows property owners to convert direct real estate holdings into a more liquid investment without an immediate tax event.

The process begins when a property owner contributes their real estate to a special partnership controlled by the REIT, known as an operating partnership (OP). In exchange for the property, the owner receives units of ownership in the OP, referred to as OP units. This contribution of property for OP units qualifies as a tax-deferred exchange under Section 721.

The property owner has effectively swapped their illiquid real estate for OP units that represent an interest in the REIT’s entire portfolio. These OP units receive distributions equivalent to the dividends paid on the REIT’s common stock, providing the owner with regular income. The tax deferral continues as long as the investor holds the OP units.

A feature of OP units is that they are usually convertible into shares of the publicly traded REIT. The conversion itself is a taxable event, as is the subsequent sale of the REIT shares. The tax is triggered at this point, not at the initial contribution. This structure provides the property owner with flexibility, allowing them to defer the tax liability while benefiting from the diversification offered by the REIT.