What Is Section 721 of the IRC?

Section 721 of the Internal Revenue Code says that when you contribute property to a partnership in exchange for a partnership interest, you generally don't owe tax on that exchange.

That's the whole idea. The rest is how it works, where it came from, and where it has limits.

What does Section 721 actually say?

Here is the full text of the statute:

26 U.S. Code § 721 – Nonrecognition of gain or loss on contribution

(a) General rule. No gain or loss shall be recognized to a partnership or to any of its partners in the case of a contribution of property to the partnership in exchange for an interest in the partnership.

(b) Special rule. Subsection (a) shall not apply to gain realized on a transfer of property to a partnership which would be treated as an investment company (within the meaning of section 351) if the partnership were incorporated.

(c) Regulations relating to certain transfers to partnerships. The Secretary may provide by regulations that subsection (a) shall not apply to gain realized on the transfer of property to a partnership if such gain, when recognized, will be includible in the gross income of a person other than a United States person.

(d) Transfers of intangibles. For regulatory authority to treat intangibles transferred to a partnership as sold, see section 367(d)(3).

(Aug. 16, 1954, ch. 736, 68A Stat. 245; Pub. L. 94–455, title XXI, § 2131(b), Oct. 4, 1976, 90 Stat. 1924; Pub. L. 105–34, title XI, § 1131(b)(3), (5)(B), Aug. 5, 1997, 111 Stat. 979, 980.)

What does Section 721 mean?

In plain words, if you put property into a partnership and get an ownership stake back, the law generally treats that as a change in the form of your investment, not a sale. You don't "cash out," so no gain is recognized at that moment. (Subsections (c) and (d) cover transfers involving foreign persons and intangible property, which rarely apply to a landlord contributing a rental.)

Your tax basis carries over to the new partnership interest. The tax is deferred, not erased.

Where did Section 721 come from?

Section 721 was enacted in 1954 as part of the Internal Revenue Code, the same code that contains Section 1031.

For decades, institutional investors have used it. The best known version is the UPREIT, where owners contribute property to an operating partnership connected to a real estate investment trust and receive units in return. Flock Homes built a way for individual landlords to use the same idea.

How is Section 721 different from Section 1031?

Both defer taxes, but they work very differently.

• A 1031 exchange is a sale and a purchase. You sell, a qualified intermediary holds the proceeds, and you must identify a replacement within 45 days and close within 180 days. The replacement must be like-kind. DSTs are a common passive destination, and they usually come with fixed hold periods and limited liquidity.
• A 721 exchange is a contribution. You don't sell the property. You contribute it to a partnership and receive partnership units, with no qualified intermediary and no 45-day or 180-day clock.

Neither is better in every case. A 1031 gets you direct ownership of another property, while a 721 gets you a share of a managed portfolio. Our comparison of 1031 vs. 721 exchanges goes further.

Are there exceptions?

Yes, and this is where a tax advisor is worth the call. These are the common ones, in plain words.

Cash or other non-partnership property (boot). If you receive cash along with your units, part of the exchange may be taxable. Flock Homes may offer limited cash at close on a case-by-case basis, and that comes with tax considerations.

Debt relief. When a partnership takes over or pays off your mortgage, that can be treated like you received cash. If the debt relieved is more than your tax basis, it can create taxable gain.

The investment-company rule. Section 721 doesn't apply in some cases where the partnership would be treated as an investment company if it were a corporation. That's subsection (b), quoted above.

Disguised sales. If a contribution is really a sale in disguise, the IRS can treat it that way.

How does Flock Homes use Section 721?

Flock Homes is the General Partner of Flock's Fund (Flock Homes OP LP). You contribute your rental to the Fund and receive partnership units. Title transfers to the Fund, and Flock Homes pays off the existing mortgage at close.

After closing, you receive cash flow quarterly, as cash or reinvested as equity. After a minimum hold period, you can redeem equity for cash per the Fund documents, and a redemption can be taxable.

A 721 can defer capital gains and depreciation recapture taxes. Your heirs may also receive a step-up in basis on your Fund equity. See our pages on tax advantages and legal structure and legacy and estate planning.

Want to see how it applies to your rental?

Submit your rental address for a free valuation. You can also read more on our 721 exchange page.

This is general information, not tax or legal advice. Please talk with your own tax advisor.