At a glance
- Both defer the tax. Only one can be repeated. A 1031 exchange moves you from one property into another and can be done again. A 721 contribution moves you into operating partnership units, and those are not real property, so the door closes behind you.
- A 1031 exchange has a clock. Forty-five days to identify, 180 days to close, and no cash may touch your hands in between.
- A 721 contribution has no clock and no like-kind test, because section 721 is about contributing property to a partnership, not about exchanging one property for another.
- Getting out of the units is the taxable event. Converting operating partnership units to REIT shares is a sale. The deferred gain arrives then, unless you hold until death.
These two provisions are usually presented as competing ways to avoid tax on a sale. They are not competitors. They answer different questions. Section 1031 asks whether you want to stay in real property you control. Section 721 asks whether you are ready to stop being a landlord and hold a security instead. A seller who has not decided that question cannot choose between them on the tax arithmetic, because on the day of the transaction the arithmetic is identical: both defer everything.
The difference shows up later, and it is structural rather than numerical. After a 1031 exchange you own real property, which means you can exchange again, and again, until a step-up in basis at death wipes out the deferred gain. After a 721 contribution you own units in an operating partnership. Section 1031 applies only to real property, and a partnership unit is not real property, so that route is closed permanently. What you have bought instead is diversification and a professionally managed income stream, paid for with control and with the ability to defer again.
What this looks like on an actual return
If you read nothing else, read this. Same building, same seller, three exits.
An apartment building held fifteen years, sold for $3,000,000 with an adjusted basis of $800,000. Of the $2,200,000 gain, $600,000 is depreciation taken over the hold. The seller files jointly and is well above the net investment income tax threshold.
| Federal tax in the year of sale | Sell outright | 1031 exchange | 721 contribution |
|---|---|---|---|
| Gain realized | $2,200,000 | $2,200,000 | $2,200,000 |
| Gain recognized | $2,200,000 | $0 | $0 |
| Unrecaptured section 1250 gain, at 25% | $150,000 | $0 | $0 |
| Long-term capital gain, at 20% | $320,000 | $0 | $0 |
| Net investment income tax, at 3.8% | $83,600 | $0 | $0 |
| Federal tax now | $553,600 | $0 | $0 |
| Can defer again later | Not applicable | Yes | No |
On the day of the transaction the two deferrals are indistinguishable. State tax sits on top of the first column, and in a high-rate state it adds materially to the $553,600. Figures are illustrative and rounded, and assume the whole gain is long-term.
The one-line version. The choice is not about this year’s tax bill. It is about whether you want to own a building you can exchange again or a security you cannot.
The 1031 exchange, and what it demands
Section 1031 is narrow and unforgiving about procedure. The statute allows nonrecognition on the exchange of real property held for productive use in a trade or business or for investment, exchanged solely for like-kind real property held for the same purpose. Two limits inside that sentence do most of the work.
Real property only. Since 2018 the section covers nothing else. Equipment, vehicles, artwork and partnership interests were all removed. This is the provision that makes the 721 route a one-way door, and it is worth reading twice before anyone sets one up.
Not held primarily for sale. A developer’s inventory does not qualify. Neither does a flip. The property has to have been held for investment or business use, judged on facts, not on what the closing statement says.
Then the clock. Replacement property must be identified within 45 days of transferring the relinquished property, and received within the earlier of 180 days or the due date of that year’s return including extensions. The deadlines are statutory. There is no reasonable-cause relief for missing them by a day, and a qualified intermediary has to hold the proceeds throughout, because actual or constructive receipt of the cash ends the exchange.
Cash out of the exchange is taxed. If you take money out, or buy a replacement worth less than what you sold, the difference is taxable now even though the rest of the exchange stands. The same is true if your debt goes down and nothing replaces it. Plan the debt, not just the price.
The 721 contribution, and what it gives up
Section 721 is broader and procedurally simpler. The statute says no gain or loss is recognized when property is contributed to a partnership in exchange for an interest in that partnership. In an UPREIT structure the partnership is the REIT’s operating partnership, and what you receive are operating partnership units, usually convertible one-for-one into REIT shares at some point in the future.
There is no 45-day clock, no qualified intermediary and no like-kind test, because nothing is being exchanged. You are becoming a partner. Your basis in the units carries over from the property under section 722, and the partnership takes the property with your basis under section 723, which is how the deferral is preserved.
What you give up is specific:
| After the transaction you have | 1031 exchange | 721 contribution |
|---|---|---|
| What you own | Real property | Operating partnership units |
| Control over the asset | Yours | The REIT’s |
| Diversification | One property, or a few | The whole portfolio |
| Ongoing income | Rents, net of what the property does | Distributions on the units |
| Ability to defer again under section 1031 | Yes | No |
| Ability to depreciate | Yes, on the replacement property | Through the partnership, not directly |
| Basis step-up at death under section 1014 | Yes | Yes, on the units |
| Liquidity | Sell the building | Convert units to shares, which is taxable |
Two exceptions to the nonrecognition are worth knowing before anyone signs. Section 721(b) switches the deferral off entirely if the partnership would be treated as an investment company, which is a real question where a partnership holds mostly securities rather than real estate. And if the property carries debt that the partnership assumes, the relief is treated as a distribution of money to you under section 752(b). Where that deemed distribution exceeds your basis in the units, the excess is taxable gain under section 731(a)(1). A heavily leveraged building with a low basis can therefore produce tax on a transaction everyone described as tax-free.
The one-way door
This is the point most articles bury, and it is the only structural difference that matters. Section 1031 applies to real property. An operating partnership unit is a partnership interest. You cannot exchange it for real property under section 1031, you cannot exchange it for other units, and there is no equivalent provision that would let you.
So the deferral you hold after a 721 contribution has exactly two endings. You convert or sell the units, and pay the tax on everything that has been deferred since the original purchase, including the depreciation recapture from the building you sold years earlier. Or you hold them until death, and your heirs take them with a stepped-up basis under section 1014, which erases the deferred gain entirely.
That second ending is a legitimate plan, and for a seller in their seventies who wants income and no management it is often the right one. It is a poor plan for someone in their forties who may want to buy a building again.
The sequence people actually use
The two provisions are frequently used in series rather than as alternatives. A seller does a 1031 exchange into a fractional interest in an institutional property, typically a Delaware statutory trust, which is treated as real property for section 1031 purposes. Some time later, often a required holding period after the exchange, the sponsor contributes that property to the REIT’s operating partnership under section 721, and the investor ends up holding units.
The appeal is that it converts a single building into a diversified portfolio without a taxable event at either step. The risks are also real. The timing of the second step is the sponsor’s decision, not yours. The valuation at which your interest converts into units is set by the sponsor. And the moment step two happens, the one-way door closes, which is why the decision to enter this structure should be made at step one rather than discovered at step two.
What to do about it
- Decide the ownership question first. Do you want to own real property you control, or a security that pays you? The tax answer follows from that. It does not lead it.
- Model the exit, not the entry. Both routes show zero tax on day one. Run the number for the year you expect to need liquidity, including the recapture from the original building.
- Check the debt before anything else. On a 1031 exchange, replace it or bring cash. On a 721 contribution, compare the debt relief against your basis in the units and find out whether section 752 produces gain.
- Diligence the sponsor as much as the tax. In a 1031 into a Delaware statutory trust followed by a 721 contribution, the sponsor controls the timing and the valuation of the step that closes the door.
- If the plan is to hold until death, write it down. A step-up under section 1014 is the whole strategy in that case, and the estate plan has to match it.
Frequently asked questions
Can you do a 1031 exchange after a 721 exchange?
No. Section 1031 applies only to real property, and what you hold after a 721 contribution is an operating partnership unit, which is a partnership interest. There is no provision that allows you to exchange those units for real property on a deferred basis. This is the reason the 721 route is described as a one-way door, and it is the single most important thing to understand before entering one.
What is a 721 exchange?
Strictly, it is not an exchange at all. Section 721 says no gain or loss is recognized when property is contributed to a partnership in return for an interest in that partnership. In an UPREIT transaction the partnership is a REIT’s operating partnership, and the investor receives operating partnership units instead of cash. There is no 45-day identification period, no qualified intermediary and no like-kind requirement, because nothing is being exchanged for like-kind property.
When do you finally pay the tax on operating partnership units?
When you dispose of them. Converting units into REIT shares, or selling them, is a taxable disposition, and the gain includes everything deferred since you bought the original property, including depreciation recapture. The one way the tax never arrives is to hold the units until death, when the basis steps up under section 1014 and the deferred gain disappears for your heirs.
Can a 721 contribution be taxable?
Yes, in two situations. Section 721(b) turns the nonrecognition off if the partnership would be treated as an investment company, which can be a live question depending on what the partnership holds. And where the partnership assumes debt on the contributed property, the relief is treated as a distribution of money to you under section 752(b); to the extent it exceeds your basis in the units, it is gain under section 731(a)(1). A low-basis, heavily mortgaged property is the case to check.
How do you roll a 1031 exchange into a 721 UPREIT?
In two steps, usually with a gap between them. First a 1031 exchange into a fractional interest in an institutional property, commonly a Delaware statutory trust, which is treated as real property for section 1031 purposes. Later the sponsor contributes that property to the REIT’s operating partnership under section 721 and you receive units. Both steps defer the gain, but the timing and the valuation of the second step are the sponsor’s decision, so the structure should be chosen deliberately at step one.
Related reading
- 1031 exchanges and the deadlines that govern them
- Depreciation recapture on the sale of rental property. What the deferral is actually carrying.
- Cost segregation and bonus depreciation. Where the deferred depreciation came from in the first place.
- Real estate professional status
Schedule a call
A short conversation about your situation, our read on it, and whether it is a mutual fit.
Sources: 26 U.S.C. § 1031, subsections (a)(1), (a)(2) and (a)(3) · 26 U.S.C. § 721, subsections (a) and (b) · 26 U.S.C. § 752 · 26 U.S.C. § 731 · § 722 and § 723 · 26 U.S.C. § 1014 · 26 U.S.C. § 1411. Figures in the worked example are illustrative. This is general information, not advice on your transaction.
