REIT Operating Partnership: OP Units, Section 721, and DownREIT

A REIT operating partnership is the limited partnership that actually holds title to the real estate in most publicly traded real estate investment trusts. The REIT itself sits at the top of the structure as general partner and majority limited partner, while the operating partnership owns the buildings and generates the income. This arrangement, called an UPREIT, exists mainly for tax reasons: it lets private property owners contribute real estate in exchange for partnership units and defer the capital gains tax they would owe on a cash sale, under Internal Revenue Code Section 721.¹

The Two-Tier UPREIT Structure

UPREIT stands for Umbrella Partnership Real Estate Investment Trust. The REIT is the sole general partner of the operating partnership and also holds a substantial limited partnership interest in it. The REIT’s primary asset is that controlling stake, not any deed to a specific building.¹

As general partner, the REIT controls the operating partnership’s decisions: which properties to acquire or sell, how to finance them, which tenants to sign, how to allocate capital improvements. Property owners who contribute buildings become limited partners with an economic stake but no operational vote. The partnership agreement obligates the general partner to act in the limited partners’ financial interest, but limited partners cannot veto an acquisition, force a sale, or override day-to-day management.

What OP Units Are

Interests in the partnership are called operating partnership units, or OP units. Each unit is designed to mirror the economic value of one share of the REIT’s publicly traded common stock. When the REIT pays a dividend to shareholders, the operating partnership pays an equivalent per-unit distribution to unit holders. Those distributions are driven in part by the tax rule that a REIT must distribute at least 90 percent of its taxable income each year to maintain its REIT status.²

OP units are not stock. They are private limited partnership interests that do not trade on any public exchange, cannot be bought through a brokerage account, and are transferable only under restrictions set out in the partnership agreement. Despite that illiquidity, OP units are the acquisition currency the REIT uses when it negotiates with private property owners, because accepting units instead of cash is what makes the transaction tax-deferred.

Contributing Property Under Section 721

Section 721 provides that no gain or loss is recognized when property is transferred to a partnership in exchange for a partnership interest.¹ A property owner who would owe a large capital gains bill on a straight sale can instead contribute the building to the operating partnership, receive OP units valued off the REIT’s current share price, and defer that gain.

The transfer runs through a negotiated Contribution Agreement that fixes what is being conveyed, how many units the contributor receives, and what the partnership is assuming.³ An independent appraisal sets fair market value, which drives the unit count. A title report confirms clean ownership. An environmental assessment protects the partnership from inheriting contamination liability. Debt disclosure documents the mortgages the partnership will assume, and the contributor’s historical tax basis records are gathered because that basis dictates the deferred gain the contributor will eventually recognize.

Where Deferral Can Break: Debt and Disguised Sales

The deferral is not automatic. Two rules can convert what looks like a Section 721 exchange into an immediate taxable event.

The first is debt allocation under Section 752. When the operating partnership assumes a mortgage on the contributed property, the contributor’s personal liability for that debt disappears, and any decrease in a partner’s share of liabilities is treated as a cash distribution from the partnership.⁴ The contributor picks up a share of the partnership’s total debt on the other side, which adds back some basis. But if the net reduction in the contributor’s debt share exceeds their outside basis in the partnership, the excess is taxable gain on day one. A heavily leveraged property in the hands of an owner with a low basis is where this typically bites. Paying down part of the mortgage before contribution is one way experienced advisors avoid it.

The second is the disguised sale rule. Under Treasury regulations issued under Section 707, a contribution of property followed by cash or other consideration from the partnership within two years is presumed to be a sale rather than a tax-deferred exchange unless the facts clearly show otherwise.⁵ A disguised sale wipes out the deferral entirely, and the debt relief itself can count as consideration. Any distributions to the contributing partner in the first two years need to clearly relate to that partner’s share of ongoing partnership profits, not look like a delayed purchase price.

The Built-In Gain Follows the Contributor

Section 704(c) requires that any built-in gain on contributed property, meaning the gap between tax basis and fair market value at the moment of contribution, be allocated entirely to the contributing partner when the partnership eventually sells that property.⁶ A contributor who transferred a building with a $2 million basis and a $10 million fair market value carries that $8 million exposure indefinitely. When the partnership sells the property, even years later and even if the contributor now holds a tiny fraction of the partnership, that $8 million lands on the contributor’s return.

This creates an inherent tension. The general partner’s portfolio decisions directly control the timing of individual contributors’ tax bills, and the two interests do not always align.

Tax Protection Agreements

Contributors address that timing risk through a tax protection agreement negotiated alongside the contribution. Under these side agreements, the operating partnership commits either not to sell the contributed property during a specified protection period, or to indemnify the contributor for the tax cost if it does sell.⁷ Protection periods commonly run somewhere between four and ten years. Some agreements also restrict the partnership from paying down or refinancing the property’s debt, because a reduction in the contributor’s allocated debt share can itself trigger gain under the Section 752 rules.

Annual Tax Reporting for Unit Holders

OP unit holders receive a Schedule K-1 from the partnership each year, not the Form 1099-DIV that regular REIT shareholders get.⁸ The K-1 breaks the holder’s share of partnership activity into ordinary income, capital gains, depreciation recapture, and other categories that flow to different lines of a personal return. K-1s often arrive late in tax season because the partnership must close its own books first. If the partnership operates in multiple states, the unit holder may pick up filing obligations in states where they do not live. Most contributors budget for a tax preparer who handles K-1s.

Redeeming Units for Cash or REIT Shares

After a holding period specified in the partnership agreement, typically about one year, a limited partner can submit a redemption request. The REIT chooses whether to satisfy that request with cash equal to the trading price of its shares or by issuing an equivalent number of common shares, and most partnership agreements give it full discretion over which method to use. When the REIT delivers shares, the exchange is generally one OP unit for one common share.

Redemption is when the deferral ends. The gain the contributor originally deferred is recognized at the exchange, based on the difference between the value of the cash or shares received and the contributor’s adjusted basis in the OP units.¹ That adjusted basis reflects the original property basis, allocated partnership liabilities, and years of income, losses, and depreciation reported on K-1s. Depreciation recapture is taxed at up to 25 percent, and the remainder is generally long-term capital gain. Running the numbers with a tax professional before requesting redemption is worthwhile.

Selling the Shares After Conversion

REIT shares received in a conversion are restricted securities. Rule 144 imposes a holding period before restricted shares can be resold in the public market: at least six months if the REIT is current in its SEC filings and has been a reporting company for at least 90 days, and one year otherwise.⁹ The time held as OP units generally tacks onto the Rule 144 period for the shares, so contributors who have held units for years can usually sell the resulting shares soon after conversion.

The Estate Planning Payoff

Section 1014 gives property acquired from a decedent a basis equal to fair market value at the date of death.¹⁰ Applied to OP units, this can wipe out the built-in gain the original contributor spent years deferring. Units contributed with a $2 million basis and worth $10 million at the holder’s death pass to heirs with a $10 million basis. The heirs can hold and collect distributions or convert and sell with little or no gain. Lifetime deferral followed by a step-up at death is the reason many older property owners choose a 721 exchange over a straight sale.

DownREIT: A Related Structure

Not every REIT uses a single operating partnership. In a DownREIT, the REIT owns some properties directly and holds interests in one or more separate limited partnerships formed with individual property contributors, rather than pooling everything into one umbrella partnership. The Section 721 deferral mechanics work the same way for contributors in either structure. The choice between UPREIT and DownREIT is driven by the REIT’s own organizational and negotiation preferences.

1
Office of the Law Revision Counsel. 26 USC 721 – Nonrecognition of Gain or Loss on Contribution
2
Office of the Law Revision Counsel. 26 USC 857 – Taxation of Real Estate Investment Trusts and Their Beneficiaries
3
U.S. Securities and Exchange Commission. Form of Contribution Agreement
4
Office of the Law Revision Counsel. 26 USC 752 – Treatment of Certain Liabilities
5
eCFR. 26 CFR 1.707-3 – Disguised Sales of Property to Partnership
6
Office of the Law Revision Counsel. 26 USC 704 – Partners Distributive Share
7
U.S. Securities and Exchange Commission. Tax Protection Agreement – Phillips Edison
8
Internal Revenue Service. Partners Instructions for Schedule K-1 (Form 1065)
9
U.S. Securities and Exchange Commission. Rule 144 – Selling Restricted and Control Securities
10
Office of the Law Revision Counsel. 26 USC 1014 – Basis of Property Acquired From a Decedent