IRC Section 721 Exchange Explained in Simple Terms

If you’re like millions of investors looking to defer the payment of capital gains taxes, then you should consider utilizing a 721 exchange. IRC Section 721 governs when a taxpayer transfers property to a partnership in exchange for a share in the partnership.

Going by the IRC description of section 721(c), a U.S. taxpayer will realize gain when that taxpayer contributes "section 721(c) property" to a "section 721(c) partnership." A section 721(c) partnership is a partnership in which the U.S. taxpayer and one or more related foreign persons own 50% or more of the partnership interests.

Read on to learn more about the IRC section 721. At Sera Capital, we can help you make the right decisions about 721 exchanges. Call us today to get help from experienced 721 exchange specialists.

A common related question we get is: can you 1031 exchange into a REIT? The answer to this involves a 721 exchange.

Putting it All Together: What is a 721 Exchange?

The IRS code section 721 allows an investor to transfer property held in a like-kind exchange for shares in a Real Estate Investment Trust (REIT) without triggering the need to pay for capital gains taxes.

For example, Mr. John, a commercial real estate investor, sells his multifamily apartment (relinquished property). Doing a 1031 exchange process, he acquires another multifamily apartment or strip mall (like-kind property) of similar or higher value. Upon the purchase of the strip mall (replacement property), he holds it for 10-20 months as a way of proving his intent to hold the property, thus qualifying for capital gains tax deferral. Then, John can easily transfer the new property to a REIT in exchange for shares in the REIT.

One of the many benefits of section 721 exceptions is that they allow investors to increase their investment liquidity and portfolio diversification while deferring the payment of capital gains and depreciation recapture taxes when relinquishing their properties.

Key Rules of the IRS Code Section 721

The IRS publication 721 is embedded with several rules requiring investors to understand them to carry out section 721 exchange. In this section, we'll highlight these rules.

Section 721: Non-Recognition of Gain and Loss on Contribution to a Partnership

Under the non-recognition of gain and loss on contribution to a partnership aspect of the 721 exchanges, there are several sub-categories are ranging from:

General Rule

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

Special Rule

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

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 a person's gross income other than a United States person.

Transfers of intangibles

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

Exceptions to the Non-Recognition Rule

There are several exceptions to the non-recognition rule under the IRC section 721. The non-recognition rule does not apply to the following:

Specific contributions that result in a reduction in a member's share of liabilities if the deemed distribution of cash resulting from the reduction exceeds the member's tax basis in his or her LLC interest. For example, this exception applies to specific contributions of encumbered property.

Contributions that are more appropriately characterized as part of a disguised sale transaction.

Contributions to an investment company as defined in Sec. 721(b).

Contributions that are not considered contributions of "property." For example, a contribution of services in exchange for an interest in the profits and capital of an LLC is not considered property.

Contributions that are deemed gifts. A 1999 IRS field service advisory (FSA 199950014) provided that a couple made taxable gifts when they took back partnership interests with a value less than the value of the assets transferred. Presumably, this same argument would apply to members in LLCs taxed as partnerships.

We Can Help You

While the IRC section 721 offers multiple benefits to investors hoping to defer capital gain taxes, it can be a complicated process with several requirements. To successfully defer the payment of capital gains taxes using a 721 exchange, you need the input of a 721 exchange specialist.

At Sera Capital, we have helped hundreds of clients defer payment of taxable gains through the use of section 721 exchange. Why don't you call us today to get started?

Schedule your free 30-minute phone call today. or read more about how you can 1031 exchange into a REIT.