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Draft Form 7217 for Reporting Property Distributed by a Partnership

Section 721: The “Other” Tax Deferred Exchange

By Janet C. Hagy, CPA-Austin

 

Often overlooked as an option for wealth planning, IRC Section 721 – Nonrecognition of gain or loss on contribution to a partnership is creating a growing business for real estate managers. But for the real estate owners, these transfers are not without risks. In the right circumstances and working with a reputable manager, Section 721 transfers can solve income recognition and estate planning challenges.

 

Under Section 721, the real estate owner irrevocably transfers their property to an operating partnership, where they become a unitholder. The transfer is a tax deferred transaction. This partnership has a large pool of other properties. The operating partnership is a subsidiary of an Umbrella Partnership Real Estate Investment Trust (UPREIT). The operating partnership typically contracts with the UPREIT to manage the properties.  The owner loses all control over the property but can receive an income stream from the property while the property is in the partnership. The unitholders do not participate in future appreciation of the real estate.

 

If encumbered property is contributed to the operating partnership, the debt will be refinanced and a portion of the overall debt will be allocated to the unitholder.

 

During the life of the operating partnership, the limited partner can sell their units or transfer them to the REIT over time. The sale or transfer of units is a taxable event. But this allows the unitholder flexibility to generate cash flow from the sale of their units and to control the timing of recognition of the deferred gain as they dispose of the units. Heirs will receive a stepped-up basis in the units upon death of the unitholder.

 

The ideal owner who could benefit from a Section 721 transfer is someone who:

  1. Is ready to sell their property but wants to postpone recognition of the gain.
  2. Does not want to acquire other traditional like-kind real estate.
  3. Wants more liquidity from their investments.
  4. Wants to simplify transfers to heirs with a more liquid asset.

 

However, besides loss of control and losing access to future appreciation of the contributed property, some of the other risks include:

  1. Managers can unilaterally decide to sell the partnership properties or transfer them to the REIT at any time. This creates a taxable event for the unitholder, possibly unexpected.
  2. Under-performing properties in the pool can affect unit values and cash distributions to the owner.
  3. Managers can incur additional debt.
  4. The management agreement may have liquidation restrictions.

 

Another type of Section 721 transfer, called a DOWNREIT, may offer the real estate owner a share of the appreciation and have other benefits, but it is also harder to meet all the requirements for gain deferral.

 

There are many real estate managers offering UPREIT and DOWNREIT products. Careful review of the rules and restrictions under the operating and REIT management agreements is imperative. Historical performance statistics, a list of the real estate portfolio and outstanding debts are also items for review. A private letter ruling on the tax effect of the transaction, especially on the DOWNREIT option, may be desirable if the transaction is sizeable.

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