By: Louis Rogers, founder and chief executive officer of Capital Square
Section 721 of the Internal Revenue Code permits the owners of real estate to contribute their property to a partnership in exchange for interests in the partnership. No tax is due on the contribution or receipt. Generally, the tax that would be due on sale of the contributed real estate is deferred until later, when the property is sold in a taxable transaction.
Real estate investment trusts, or REITs, typically acquire their real estate through an operating partnership that owns a large number of properties. Many REITs use OP exchange transactions to acquire desirable real estate from owners of real estate in a tax-friendly manner. Section 721 is old law and not very exciting outside the context of an OP transaction with a REIT.
OP Transactions with a REIT
Many REITs use OP transactions to bulk up — to acquire desirable real estate from owners of the real estate in a tax-friendly manner. REITs typically acquire their real estate through an operating partnership that owns a large number of properties, frequently with a value in the billions of dollars. By exchanging specific real estate for OP units, real estate owners are able to receive OP units backed by a much larger, more diversified portfolio (billions of dollars of real estate). Diversification is one of the primary drivers of OP transactions.
The operating partnership is owned by the OP investors and the REIT. In this structure, the REIT is the general partner of the operating partnership. Typically, REIT stockholders buy their shares on the market, seeking cash flow from dividends and appreciation potential on their stock. The economics of property ownership, including dividends from the properties, flow to the OP unitholders and the REIT based on the relative value of their investment. By using this structure, REITs are able to structure tax-efficient transactions with property owners (who defer the taxes that would be due on a sale) and, at the same time, raise capital from REIT’s stock investors.
What is a Section 721 Exchange?
Section 721 is one of the most common provisions in the tax code; it is triggered whenever property is contributed to a tax partnership. Note that in modern times, limited liability companies are the most popular form of tax partnership, but more old-fashioned limited and general partnerships qualify equally for 721 treatment.
Tax Law Basics
In a Section 721 exchange, the tax basis of the contributor carries over to the OP units received in exchange for the property. The gain that would be recognized by the contributors in a taxable sale is deferred until the operating partnership sells the contributed property or the OP investors sell their OP units.
Section 721 is a mundane provision that becomes much more interesting in the context of an operating partnership transaction with a REIT. These transactions have many names: an OP transaction, UPREIT transaction, or Section 721 exchanges.
Typical Formation of a Real Estate Partnership
It is very common to form a new partnership (frequently an LLC) to acquire real estate. The transaction is simple: the owners of real estate contribute their real estate to a new partnership in return for interests in the partnership. It makes good sense that, under Section 721, there is no tax to the contributing partners or to the partnership since none of the parties have cashed out or liquidated their investment. This is very similar to a Section 1031 tax-deferred exchange, where the owners of real estate exchange their relinquished property for like-kind replacement property and do not cash out.
In Sections 721 and 1031, tax policy supports the notion that parties who have not cashed out or liquidated their investment should not be subject to current taxation. In both cases, the taxpayer’s basis carries over to the new investment (OP units under 721 or replacement property under 1031).
Also, gain is deferred and there is no current taxation. How long is the gain deferred? Until the new investment is sold in a taxable transaction, that is, until the OP units or the 1031 replacement property is sold in a taxable transaction. The OP units can be held for a very long time, making the tax deferral nearly perpetual. The same is true under Section 1031 because real estate owners may structure Section 1031 exchanges over and over and over again, making the tax deferral under Section 1031 nearly perpetual. Note, the heirs of the OP or exchange investors generally will enjoy a step-up in tax basis on death. This makes the tax deferral under Sections 721 and 1031 potentially perpetual for investors who hold long-term and do not cash out.
Illustration of a 721/OP Exchange Transaction
Let’s say Mr. X owns investment-grade real estate that Z REIT would like to acquire. The parties may arrange a Section 721/OP transaction as follows:
Mr. X contributes his real estate to the operating partnership of Z REIT in return for OP units.
The OP units will have a value equal to the equity value of the real estate, typically determined by MAI appraisals. There is no tax to Mr. X or the operating partnership. Mr. X’s tax basis carries over to his OP units and Mr. X essentially becomes a passive owner (partner of the operating partnership). This is an exceptionally tax-efficient transaction compared to a taxable sale and reinvesting in real estate after tax.
If the real estate is encumbered by a mortgage, it is common for the operating partnership to repay or assume Mr. X’s mortgage indebtedness and release him from the obligations as a borrower.
The value of Mr. X’s real estate that is used to determine the value of his OP interests is computed based on the appraised fair market value less the amount of debt paid off or assumed by the operating transaction in the transaction.
Benefits of an OP Transaction to the Real Estate Owner/Contributor
Ownership of OP units may provide the following benefits to a contributing investor:
- Deferral of capital gain taxes is the primary incentive to conduct an OP transaction.
- Access to a diversified portfolio of institutional quality real estate via the operating partnership is an important secondary benefit. The real estate owner converts an interest in one or more specific properties into an interest in a much larger and more diversified portfolio of properties.
- Realization of the economic benefits of the REIT’s entire portfolio, including capital appreciation and distributions of operating income.
- Convertibility of OP units into REIT shares to provide liquidity.
- Management of tax gain through partial conversion and liquidation of OP units over time, at the OP unitholders discretion.
- Full divisibility of OP units creates additional options and simplified estate planning opportunities.
- Reduced management responsibilities by exchanging actively managed real estate for passive OP units.
- Retention of income from real estate via distributions on the OP units.
- Upon death, receipt by heirs of a stepped-up basis in OP units (permanent tax-deferral).
Option to Exchange OP Units for REIT Stock
Many REITs have an option to exchange OP units for REIT stock. This is a taxable transaction but is used to create liquidity because the newly received REIT stock can be immediately sold on the market. Thus, while the OP/REIT stock exchange is taxable, it can be used to create immediate liquidity, providing cash to pay taxes and cash out of OP transactions. Unless there is need for liquidity, the exchange option is not exercised by OP investors.
Section 721/OP Transactions — Tax-Efficient but the Needle in the Haystack!
To be the subject of a Section 721/OP transaction, the property must meet the REIT’s investment criteria, which typically means investment-grade real estate. Most real estate IS NOT investment grade.
By contrast, Section 1031 applies to all like-kind real estate. Section 1031 exchanges are common — they take place everywhere you find appreciated investment real estate and not just the rare, narrow category of investment grade property.
In conclusion, while exceptionally tax efficient, OP transactions are very rare — OP transactions are the needle in the haystack, while Section 1031 exchanges are the haystack.
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The views expressed in the preceding article are those of the author and do not necessarily reflect those of The DI Wire.