721 Exchange
A 721 exchange is a tax-deferred transaction under IRC Section 721 in which a real estate owner contributes property to a partnership — typically a REIT operating partnership — in exchange for partnership interests, deferring recognition of capital gains on the contributed property.
Section 721 of the Internal Revenue Code provides that no gain or loss is recognized when property is contributed to a partnership in exchange for an interest in that partnership, provided the transaction qualifies under the applicable rules. In real estate, this provision is most commonly used in the UPREIT context, allowing property owners to contribute appreciated real estate to a REIT's operating partnership in exchange for OP units without triggering immediate capital gains tax.
The mechanics distinguish the 721 exchange from a 1031 exchange. In a 1031 exchange, the taxpayer is selling one property and purchasing a replacement property of like-kind. In a 721 exchange, the taxpayer is contributing property to a partnership in exchange for a partnership interest, not another property. These are different code sections with different requirements, but both result in deferral of capital gains recognition.
A common strategy involves combining a 1031 exchange with a subsequent 721 exchange. An investor might complete a series of 1031 exchanges over many years, ultimately exchanging into a Delaware Statutory Trust that has an UPREIT conversion feature. When the DST manager elects to contribute the trust's assets to a REIT operating partnership, the DST investors receive OP units in the UPREIT via a 721 exchange, at which point they hold a more diversified, professionally managed real estate interest.
OP units received in a 721 exchange carry a carryover basis from the contributed property. The gain deferred at contribution is recognized when the OP units are ultimately converted to REIT shares or cash, at which point the investor controls the timing of that tax event.
The 721 exchange is a sophisticated strategy best suited for investors with large amounts of appreciated real estate and a desire to transition from active or concentrated ownership to a passive, diversified real estate interest.