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A little clarity for your next decision.
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Investor WorkspaceA little clarity for your next decision.
By Jerry Baker
A 721 exchange can replace direct property ownership with operating partnership units that may be easier to divide among heirs. It can also defer tax on a qualifying property contribution, but it does not create an estate plan or erase every future tax. The useful questions are who will inherit the units, how their tax basis will be set, and when they can get cash.
A rental property can mean different things to different family members. You may see years of work and a source of income. One child may see a business worth keeping. Another may see repairs, tenants, and a job they never wanted.
Moving real estate into an operating partnership can change that work. The partnership owns and manages the property. You hold units, often called OP units, under its agreement. In a qualifying Section 721 contribution, gain generally is not recognized when property is exchanged for a partnership interest. Exceptions and related rules still matter. This is a partnership transaction, not a direct purchase of REIT shares. [1]
That change may help your family. It may also leave them with an asset they cannot sell when they wish. Before comparing estate benefits, list each heir’s likely needs: current income, near-term cash, long-term growth, and willingness to handle tax forms. The plan should fit those people, not just produce an attractive tax diagram.
I would also ask a less comfortable question: would this be a sound investment if the estate benefit were smaller than expected? Property quality, debt, fees, management, and exit rights still deserve a full review.
Tax basis is the amount used to measure certain gains, losses, and deductions. It is not always what an investment is worth. For inherited property, basis generally becomes fair market value at the date of death. A valid alternate valuation election or another exception can change that result. [2]
People often call this a “step-up in basis.” The phrase leaves out two points. First, value can fall, which can produce a step-down. Second, inherited partnership units raise questions about two different kinds of basis. A new basis in the units does not by itself reset every building’s tax basis inside the partnership.
Consider a simple illustration. An owner’s basis in units is $600,000 just before death. The units’ fair market value at death is $1.5 million. Assume the general inherited-basis rule applies, and ignore partnership debt, income in respect of a decedent, and other adjustments.
Under those assumptions, the heir’s starting basis in the units is $1.5 million. The increase is $900,000. That is a basis change, not a $900,000 tax saving or a promise of a tax-free sale. The actual return also depends on later events and the partnership’s tax records.
The language sounds more difficult than the idea. “Outside” basis belongs to the owner of the partnership interest. “Inside” basis belongs to the partnership’s assets.
| Tax record | What it measures | Why your heirs need it |
|---|---|---|
| Outside basis | The heir’s tax basis in the OP units. | Helps determine tax from unit sales, cash distributions, and other events. |
| Inside basis | The partnership’s tax basis in its buildings and other assets. | Helps determine depreciation and gain when those assets are sold. |
| Section 743(b) adjustment | A special adjustment to partnership asset basis for a particular new owner. | Can help align that owner’s tax treatment with the basis in the acquired units. |
A Section 743(b) adjustment generally follows a qualifying transfer when the partnership has a Section 754 election in effect. It is specific to the person who acquired the interest. It does not simply raise the common basis for all partners. The amount and its allocation among assets require tax work. [3]
The partnership makes the Section 754 election. The heir cannot create it just by adding a line to a personal tax return. An election is generally filed with the partnership’s timely return, including extensions, for the year of the transfer. An existing election can remain in effect for later years. [4]
There are also mandatory basis-adjustment rules for certain substantial built-in losses. So “no election means no adjustment, ever” is too broad. The current Form 1065 instructions address those rules. [5]
Ask the manager whether an election is in effect, what the agreement requires after an owner dies, and who calculates each heir’s adjustment. Request written answers before treating an estate illustration as reliable.
A proper basis adjustment can matter a great deal. It still does not make “all deferred tax disappears” a safe description of every 721 estate plan. Debt, asset allocations, special income items, elections, and the form of a later exit can affect the answer.
Income in respect of a decedent is one example. This term covers certain income earned or due before death that was not properly included on the final income tax return. It can remain taxable when the estate or beneficiary receives it. Publication 559 explains the rule and several examples. [7]
Separate that pre-death income from income earned after death. An heir who receives an investment generally does not owe income tax merely because it was inherited. But later rent, partnership income, dividends, or gains can be taxable. Inheriting an asset is not the same as making its future income tax-free.
The estate team should reconcile the owner’s final return, the estate’s returns, and the heirs’ starting records. Otherwise, one person may assume a tax item vanished while another assumes someone else reported it. A clear handoff is worth more than a one-line claim about a step-up.
A trust can serve several goals: manage assets during incapacity, guide distributions, or provide for a family member who should not receive assets outright. The tax result depends on the trust’s terms and the facts. The word “trust” does not answer the basis question.
IRS Revenue Ruling 2023-2 addresses a specific irrevocable grantor trust. The owner was treated as owning its assets for income tax purposes, but the assets were not included in that owner’s gross estate. Under the ruling’s facts, the assets did not qualify for a basis adjustment under Section 1014 at the owner’s death. [6]
The lesson is narrow but important: grantor-trust status for income tax purposes does not automatically produce an inherited-basis reset. Have your estate attorney and CPA review your actual trust. Do not assume every revocable and irrevocable trust works the same way.
A lifetime gift is different from an inheritance. For appreciated property, the recipient generally takes the donor’s basis, subject to applicable adjustments. Special rules apply when gift-date value is below the donor’s basis. A gift can therefore move an asset to a child without removing its built-in gain. [2]
Before gifting units, review transfer consent, debt, tax reporting, and the recipient’s needs. A gift-tax return may be needed even when no current gift tax is owed. [14] Estate planning is a balance of control, access, taxes, and family goals; basis alone should not choose the plan.
An income-tax basis adjustment does not decide whether an estate owes estate tax. Federal estate-tax filing depends on the rules for the year of death, the owner’s status, the estate’s value, and other factors. Prior taxable gifts can matter. State rules may also differ.
Federal estate-tax rules look beyond the assets passing through probate. Trust interests, certain insurance proceeds, and other property can enter the analysis. Avoid assuming “outside probate” means “outside the taxable estate.” The Form 706 instructions explain what an executor must review. [8]
A married couple should also ask about portability. A qualifying estate may file Form 706 to transfer a deceased spouse’s unused federal exclusion to the survivor, even when it would not otherwise need to file. Filing deadlines and relief rules apply. This is a decision for the estate team, not a box the investment manager checks.
Your family’s filing needs may change after a marriage, divorce, major gift, or large change in wealth. Review the plan when life changes. A document written years before the property contribution may not describe who should control or receive the new partnership units.
An estate can have valuable assets and still be short of cash. Legal costs, taxes, debts, and support for a surviving spouse may arrive before units can be redeemed. Death does not automatically create a right to demand cash from the partnership.
Federal estate-tax returns and payments are generally due nine months after death. A filing extension does not by itself extend the payment deadline. Special payment extensions or installment rules have conditions; they should not be treated as a built-in feature of owning OP units. [8]
Ask for the specific provisions that address death and disability. Does the program offer a special redemption request? Is approval required? Can the program cap, postpone, or suspend payments? Which value is used, and can fees reduce it?
Private investments can be difficult to resell. Nontraded REIT redemption programs can also impose limits or stop repurchases. Even if units can later be exchanged for shares, the type of shares and the program’s terms matter. A path to potential liquidity is not cash already in the estate’s bank account. [9] [10]
Build the cash plan from assets the executor can actually access. Then test a delay: what happens if the requested redemption takes longer, distributions fall, or the investment’s value declines?
Units may make it easier to divide an interest among several heirs. That can avoid having every child help decide whether to replace the roof on one building. But dividing ownership does not remove the partnership agreement.
Check whether the transfer is permitted, which documents are required, and whether recipients become full partners or receive only economic rights. Ask about minimum holdings, account setup, trust ownership, and any investor requirements. The answer can vary by offering and transfer type.
Equal unit counts may be simple when everyone receives the same class on the same terms. They are less useful when the estate has different unit classes, liquid assets, or debts. A cash account and a restricted interest with the same stated value do not offer the same access.
Suppose one child needs money for a home while another wants long-term income. Giving both the same restricted investment may look equal on paper but ignore the reason each needs an inheritance. Your attorney can evaluate other ways to divide the estate without assuming the partnership must redeem either child.
Do not promise independent exits until the agreement supports them. Separate accounts can reduce family coordination, but the manager may still control when either heir receives cash or shares.
A plan to hold units until death can span many years. During that time, the partnership may earn taxable income, sell properties, change its debt, or alter distributions. The initial 721 contribution does not shield every later event from tax. [11]
Partners generally report their allocated income even if the partnership does not distribute cash. A Schedule K-1 reports tax items; it is not a statement of cash received. Review both the tax estimate and the actual distribution when planning your spending. [13]
There is also an investment question. Can your family tolerate the property mix, leverage, management decisions, and fees? A larger portfolio can still suffer losses. The person who chose the investment may understand it well, while the person who inherits it may need a simpler explanation.
Write down the reasons you selected the program and the risks you accepted. Include the tax protection agreement, if any, but explain its limits. A contract intended to reduce certain tax risks is not a guarantee against market losses or every taxable event.
Possible choices may include keeping the units, requesting redemption, or receiving REIT shares under the agreement. There may also be a permitted private transfer. None should be assumed to be available on demand.
Each choice needs both a tax review and a practical review. A unit redemption or exchange for shares can be taxable, depending on its structure and the heir’s facts. A higher inherited basis may reduce gain, but it does not make the analysis unnecessary.
Ordinary OP units and REIT shares do not qualify as replacement real property for a Section 1031 exchange. The narrow regulatory exceptions do not turn a normal UPREIT interest into a direct real estate holding. Heirs cannot simply exchange those securities for a rental property under the usual 1031 rules. [12]
That does not prevent an heir from owning other real estate or using Section 1031 for a separate qualifying property. It also does not mean units must be held forever. The family should compare after-tax cash, timing, risk, and the choices actually offered.
The value shown on an account statement may be useful, but it is not proof of what the estate can receive in cash. Ask when it was set, what it measures, and whether it reflects your exact unit class. A tax value, a program value, and a sale price may serve different purposes.
For estate reporting, the team needs support for the value used on the required date. Do not carry forward an old statement just because it is the easiest number to find. Ask the attorney and CPA what records or valuation work are needed. Use consistent records when the law requires basis to match an estate-tax value. [2] [8]
There is a second issue to solve before death: who can act if you become too ill to handle the account? Your legal team can review signing powers and trust roles. Then ask the manager how those powers are put into effect. A document in a desk drawer does little good if nobody can find it when a form needs to be signed.
Try a short family exercise. Imagine the person who normally handles the investment is unavailable for six months. Who reads the notices? Who receives cash? Who pays tax? Who can ask questions or make a request? Which steps require the manager’s consent?
Write the answers in plain language and keep them with the legal records. This does not replace legal documents. It helps the people named in them understand their next step. Avoid relying on shared passwords as a substitute for proper authority.
Review the same file after a move, a change in trustee, or a change in the investment’s terms. A plan can be sound when signed and become hard to use because the contact details or account title were never updated.
An estate plan is harder to carry out when only one person knows where the records are. Create a secure file with current contacts and a short explanation of the investment. Give your chosen decision-maker a way to find it.
After a death, notify the partnership promptly and ask what it needs to update ownership and tax records. Special written-notice rules can apply to a transfer at death when a Section 754 election is in effect. Do not assume sending a death certificate to a sales contact satisfies the tax process. [3]
The estate team should agree on valuation support, applicable elections, and responsibility for each return. Keep copies of what was sent and the manager’s response. Good records help heirs make informed choices without rebuilding decades of tax history from scratch.
Not as a blanket rule. Inherited units may receive a new outside basis under Section 1014. Asset-level treatment inside the partnership, Section 743(b) adjustments, special income items, and later transactions still need review. Do not rely on an illustration that treats every tax as automatically erased.
No. OP units are partnership interests; REIT shares are stock in the REIT. The agreement may provide a path from units to cash or shares, but timing, approvals, tax consequences, and resale rights can differ. Your estate plan should name the asset you actually own.
Only if the agreement and applicable rules permit the transaction. Inheritance does not guarantee a buyer or an immediate redemption. Review any special death provisions, pricing rules, caps, and suspension rights before relying on units to pay a near-term expense.
The partnership does. The heir should ask whether an election is already in effect and how the manager handles the resulting basis work. A separate adjustment may also be mandatory in certain loss situations. The estate’s CPA and the partnership’s tax team should coordinate.
That depends on your goals, estate size, need for control, and tax facts. Gifts of appreciated property generally carry the donor’s basis, while inherited-property rules are different. Transfer restrictions and debt can also matter. Compare the full plan with your attorney and CPA before signing a gift.
No. Trust terms, ownership, estate inclusion, and the inherited-basis rules matter. Revenue Ruling 2023-2 shows why grantor-trust status alone is not enough. Your advisors need to review the actual trust and investment, not just the account’s name.
Start with who receives the units, who can act during incapacity, and how the family will cover near-term bills. Then review inherited basis, partnership elections, transfer rights, and tax filings. A useful plan gives your family both clear instructions and realistic choices.
Educational information, not an offer or a personal tax, legal, or investment recommendation. Examples are hypothetical and omit stated adjustments. Tax treatment depends on your facts and current law. Review your transaction with your CPA, attorney, and qualified intermediary. Real estate investments can lose value and may be illiquid.
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