In brief
A 721 exchange uses Section 721 of the tax code to contribute real estate to a partnership, typically a REIT’s operating partnership, in exchange for operating partnership (OP) units. Gain is generally deferred. The OP units usually pay distributions similar to the REIT’s dividends and can later be converted into REIT shares or cash, which is generally taxable. A REIT structured this way is called an UPREIT.
How an UPREIT works
Most large REITs do not own their buildings directly. They own them through an operating partnership, with the REIT itself as the main partner. That structure, called an umbrella partnership REIT or UPREIT, is what makes a 721 exchange possible: because the properties sit inside a partnership, an owner can contribute real estate to it the same way partners contribute property to any partnership, generally without recognizing gain.
- Contribute. You transfer your property, or your interest in it, to the operating partnership.
- Receive OP units. In return you receive operating partnership units, valued by reference to the REIT’s share price or net asset value. Your tax basis carries over to the units.
- Collect distributions. OP units typically receive distributions comparable to the REIT’s dividend, and you receive tax reporting as a partner.
- Convert or hold. After any required holding period, you can usually redeem units for REIT shares or cash. Each conversion is generally a taxable sale of those units. Units held until death may receive a step-up in basis under current law.
The DST-to-721 path
REITs rarely accept a single small property directly. The more common route for individual investors is two steps:
- Sell your property and complete a 1031 exchange into a Delaware Statutory Trust sponsored by a REIT that runs an UPREIT program.
- Later, often after two to three years and at the sponsor’s option, the REIT acquires the DST’s property by issuing OP units to the DST investors in a 721 exchange.
Read the offering documents closely. In many programs the sponsor, not the investor, decides whether and when the property rolls into the REIT, and investors may not be able to choose a fresh 1031 exchange instead. Our DST guide covers how DSTs work, and our DST vs. TIC vs. REIT comparison shows where this route fits among the alternatives.
721 exchange vs. 1031 exchange
| 1031 exchange | 721 exchange | |
|---|---|---|
| What you receive | Another real property (or a DST interest) | Operating partnership units |
| Deadlines | 45 days to identify, 180 days to close | No identification or closing deadlines |
| Diversification | Usually one or a few properties | Exposure to the REIT’s whole portfolio |
| Future exchanges | Can exchange again and again | Generally no further 1031 exchanges |
| Getting to cash | Sell the property (taxable) | Convert units to shares or cash in pieces (taxable) |
| Control | Full with direct property; none in a DST | None; REIT management decides |
Potential advantages
- Diversification without a sale. One building’s worth of equity becomes a small slice of a portfolio spread across many properties, tenants, and markets.
- No 45- and 180-day clock. There is no replacement property to find under deadline pressure.
- A gradual path to liquidity. Converting units a portion at a time lets you choose when to recognize gain and spread it across tax years.
- Simpler estate planning. Units are easier to divide among heirs than a building, and under current law they may receive a step-up in basis at death.
- No more landlord duties. Management, leasing, and capital decisions belong to the REIT.
What you give up
- The 1031 option. Partnership interests do not qualify for a 1031 exchange, so once you hold OP units you generally cannot exchange back into real property tax-free.
- Taxable exits. Converting units into REIT shares or cash triggers the deferred gain, including depreciation recapture, on the units converted.
- Valuation and liquidity risk. For non-traded REITs, unit values are based on periodic net asset value estimates and redemptions can be limited or suspended. For listed REITs, units track a share price that moves with the stock market.
- Debt and disguised-sale rules. If your property carries a mortgage, how that debt is handled can trigger gain. Distributions shortly after the contribution can also be treated as a partial sale. These require careful structuring with a tax advisor.
- Fees and control. REIT and sponsor fees apply, and you have no say in how the portfolio is managed.
Because conversions trigger recapture of past depreciation, it helps to know how much is built up. See our guide to depreciation recapture on rental property.
Questions to ask before choosing a 721 route
- Who decides whether and when the DST property is contributed to the REIT, and can I opt out?
- How are OP units valued at contribution, and how often is the REIT’s net asset value updated?
- What holding period applies before I can redeem units, and are redemptions limited?
- What are the total fees at the DST level and the REIT level?
- How would converting units over several years fit my income tax and estate plans?
Frequently asked questions
What is a 721 exchange?
A 721 exchange uses Section 721 of the Internal Revenue Code, which generally lets a property owner contribute real estate to a partnership in exchange for a partnership interest without recognizing gain. In real estate, the partnership is usually the operating partnership of a REIT, and the owner receives operating partnership units instead of cash.
What is an UPREIT?
An UPREIT, or umbrella partnership real estate investment trust, is a REIT that owns its properties through an operating partnership. Because the properties sit inside a partnership, owners can contribute real estate to it in a tax-deferred 721 exchange and receive operating partnership units that generally earn distributions similar to the REIT’s dividends.
Can I do a 1031 exchange into a REIT?
Not directly, because REIT shares are not real property. A common path is a two-step approach: complete a 1031 exchange into a Delaware Statutory Trust whose sponsor runs an UPREIT program, and later the DST property may be contributed to the REIT’s operating partnership in a 721 exchange. After that step, future 1031 exchanges are generally no longer available for that investment.
Is converting operating partnership units to REIT shares taxable?
Generally yes. Redeeming or converting operating partnership units into REIT shares or cash is typically a taxable event that triggers the deferred gain on the units converted. Many investors convert gradually over several years to spread the tax, or hold units until death, when heirs may receive a step-up in basis under current law.